Measuring and Increasing Profit

What this topic is all about

• What is profit (a recap from Unit 1)• Profit & profitability• Return on capital• Ways to improve profit• The difference between profit and cash

flow

Unit 1 Reminder – What is Profit?

Profit is thereward or return for

taking risks & making investments

Profit as an Objective

• For most businesses, making a profit is a key objective

• Profit is the most important source of cash flow & finance for a business

• Remember that there can be reasons for running a business other than the “profit motive”

Calculating Profit

Total Salesless

Total Costs=

Profit (or Loss)

Example

Sales Costs Profit or Loss?

£100,000 £75,000 £25,000 (profit)

£100,000 £125,000 £25,000 (loss)

Total sales > total costsTotal costs > total salesTotal sales = total costs

= Profit= Loss= Break-even

Two Ways of Measuring Profit

• Profit in absolute terms– The £ value of profits earned– E.g. £50,000 profit made in the year

• Profit in relative terms– The profit earned as a proportion of sales achieved

or investment made– E.g. £50,000 profit from £500,000 of sales is a profit

margin of 10%– E.g. £50,000 profit from an investment of £1

million = a 5% return on investment

Two Key Terms to Remember

Capital The amount invested into a business or project

Net profit margin

The percentage return made on sales; calculated as net profit divided by sales

NetProfit

Margin

Net Profit Margin – What is Net Profit?

Net profit is what is left after all the costs of

a business have been

taken from its sales revenue

Example £’000Sales 150

Wages (50)

Energy costs (25)

Marketing (15)

Other overheads (30)

NET PROFIT 30Net profit margin 20%

Net Profit Margin – the formula

Net profit margin =

Net profit (before tax)

SalesX 100

Note: net profit margin is expressed as a percentage

What does Net Profit Margin tell us?

• How effectively a business turns its sales into profit

• How efficiently a business is run• Whether a business is able to “add value”

during the production process (a high margin business must be doing something right!)

The Importance of Comparison (1)

The net profit margin of a business should be compared with other competitors in the same

market, and over time

Example Company A£’000

Company B£’000

Company C£’000

Sales 150 250 500

Net profit 50 25 125

Net margin 20% 10% 25%

The Importance of Comparison (2)

Example Company A£’000

Company B£’000

Company C£’000

Sales 150 250 500

Net profit 50 25 125

Net margin 20% 10% 25%

Company C makes the highest net margin of these three & also the highest sales. So it makes the largest net profit too

Company A makes a higher net profit than Company B even though its sales are lower – because it has a higher net profit margin

ReturnOn

Capital

What is Capital?

Capital is the amount invested in a

businessReturn on capital is

the percentage return on that

investment

Example £’000Net profit 200

Capital 2,500

Return on Capital 8%

Return on capital– the formula

Return on Capital =

Net profit (before tax)

Capital investedX 100

Note: return on capital is expressed as a percentage

What does Return on Capital tell us?

• A measure of the returns made from investing in the business

• How good is the business at converting money invested into profit?

• Provides a means of comparison with other investment opportunities

• Opportunity cost (remember from Unit 1!) – what an investor could have done by investing elsewhere

Methods of Improving

Profits

The Basics of Increasing Profits

Sales

Variable Costsless

Fixed Costsless

Net Profit=

Increase quantity sold

Increase selling price

Reduce VC per unit

Reduce fixed costs

Increase output

Increase quantity sold

Why? Higher sales volumes = higher sales, assuming that the selling price is not lowered Makes better use of production capacity (i.e. fixed costs should not rise) May result in higher market share

Will it work?

Depends on elasticity of demand Sales value may actually fall if price has to be reduced to achieve higher sales volumes Does business have capacity to sell more?

Why it might not work

Competitors are likely to respond Marketing efforts may fail – e.g. promotional campaign does not generate results Fixed costs might actually rise – e.g. higher marketing

Increase selling price

Why? Higher selling price = higher sales (assuming quantity sold does not fall in response) Maximises value extracted from customers Customers may perceive product as higher quality No need for extra production capacity

Will it work?

Depends on price elasticity of demand Sales value may actually fall price rise is matched by an even bigger fall in quantity sold It will work if customers remain loyal and still perceive product to be good value

Why it might not work

Competitors are likely to respond (e.g. prices lower) Customers may decide to switch to competitors

Reduce variable costs per unit

Why? Increase the value added per unit sold Higher profit margin on each item produced and sold Customers do not notice a change in price

Will it work?

Yes, if suppliers can be persuaded to offer better prices Yes, if quality can be improved through lower wastage Yes, if operations can be organised more efficiently

Why it might not work

Lower input costs might mean lower quality inputs – which can lead to greater wastage Customers may notice a decrease in product quality

Increase output

Why? Provides greater quantity of product to be sold Enables business to maximise share of market demand Spreads fixed costs over a greater number of units

Will it work?

Yes, if the extra output can be sold (e.g. finding a new market, offering a lower price for a more basic product) Yes, if the business has spare capacity

Why it might not work

A dangerous option – what if the demand is not there? Fixed costs might actually rise (e.g. stepped fixed costs) Production quality might be compromised (lowered) in the rush to produce more

Reduce fixed costs

Why? A drop in fixed costs translates directly into higher profits Reduces the break-even output Often substantial savings to be made by cutting unnecessary overheads

Will it work?

Yes, provided costs cut don’t affect quality, customer service or output A business can nearly always find savings in overheads

Why it might not work

Might reduce ability of business to increase sales Intangible costs – e.g. lower morale after making redundancies

Some more complex approaches

• Reduce product range– Business often has too many products = complex

operations & inefficiency– Some products may be very low-margin or even

loss-making

• Outsource non-essential functions– A way of reducing fixed costs– Focus the business on what it is good at– Areas to outsource: e.g. IT, call handling, finance

Difference between profit and cash flow

Two Different Concepts

Sales

Variable Costsless

Fixed Costsless

Net Profit=

What is Profit?

Cash Inflows

Cash outflowsless

Net Cash Flow=

What is Cash Flow?

Where cash flow differs from profit

• Timing differences– Sales to customers made on credit– Payments to suppliers

• The way that fixed assets are accounted for– Payment for fixed asset = cash outflow– Cost of fixed asset = treated as an asset not a cost– Depreciation is charged as cost when the value of

fixed assets is reduced

Some examples

TransactionExample

What happensto Profit?

What happensto Cash Flow?

Customer buys goods for £50,000 on 60 days credit

Sales of £50,000 are recognised immediately

Cash inflow of £50,000 when the customer actually pays

Marketing campaign costing £10,000 ordered from marketing agency

Cost of £10,000 included in marketing costs

Cash outflow of £10,000 when the marketing agency is paid

New factory machinery bought for £150,000

No effect. £150,000 added to the value of fixed assets

Cash outflow of £150,000 paid to supplier of machinery

Depreciation charge of £100,000 to reflect use of factory fixed assets

Depreciation of £100,000 included as a cost

No effect on cash flow

Test Your Understanding

http://www.tutor2u.net/business/quiz/improvingprofit/quiz.html

Measuring and Increasing Profit