Profit = total revenue – total costs
A business can increase its profit, therefore, by:
– increasing its total revenue
– decreasing its total costs
Profit can be measured in two ways:
– In absolute terms (the monetary value of profits earned)
– In relative terms (the profit earned as a proportion of sales achieved or investments made)
Key terms in regards to profit are:
- capital: the amount invested into a project or business
- profit margin: the profit that’s made in proportion of sales revenue
- gross profit: this is calculated by subtracting from sales venue variable costs only (gross profit = sales revenue – variable costs)
- net profit: this is calculated by subtracting total costs from sales revenue (net profit = sales revenue – total costs)
Profitability can be measured using:
– net profit margin
– return on capital
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Net profit margin
This is the remainder once all the costs of a business have been deducted from the sales revenue.
net profit margin = (net profit / sales revenue) x 100
The net profit margin shows:
- How effectively a business has been able to transform its sales into profit
- How effectively a business is run
- If a business is capable of adding value during its production process
It’s important that the value of the net profit margin is compared with other competitors within the same industry and over a certain period of time.
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Return on capital
Profitability can also be measured using return on capital. This is calculated by comparing the profit made with the amount of capital invested. The higher the ratio result, the more profitable the investment was. This could be an indicator of good investment management.
return on capital = (net profit / capital invested) x 100
Return on capital can be used:
- to show the returns made from investing in a business
- to indicate how good a business is at converting invested money into profit
- as a comparison with alternative investment opportunities
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Increasing profit
Methods of increasing profit include:
- increasing sales without reducing the net profit margin
- increasing the net profit margin by reducing the variable cost per unit
- increasing the net profit margin by increasing the price
- increasing the net profit margin by reducing the fixed costs
These methods are described in greater detail in the table below:
| Method | Reasoning | Chances of succeeding | Chances of failing |
| Increasing quantity sold | * As long as the price isn’t lowered then higher sales volumes means higher sales*Production capacity is used more efficiently* Could lead to a higher share in the market | * It’s dependant on elasticity of demand* If the price needs to be reduced in order to achieve higher a higher sales volume then the sales value could drop* The business should have the capacity to sell more | * Competition will probably respond* The marketing may not be successful* The value of fixed costs could rise |
| Increasing the selling price | * As long as the quantity sold doesn’t decrease then more profit will be made* It maximises the value taken from the consumers* Consumers may regard it as a better quality product* Extra production capacity isn’t required | * It depends on price elasticity of demand* If matched by more being sold then the sales value may drop in price* Consumers need to remain loyal and continue to regard the product as good value for money* If matched by a larger drop in quantity sold then the sales value could decrease | * Competition will probably respond* Consumers could decide to switch to a rival company |
| Reduction in the variable costs per unit | * Increase the value added per unit sold* Every item produced and sold has a larger profit margin* Consumer aren’t aware of any price change | * Suppliers need to offer better prices* Waste needs to be minimised* Operations need to be organised more efficiently | * More wastage could result due to lower input costs leading to lower quality inputs* Consumer could notice that the product’s quality has been reduced |
| Increase the output | * A greater amount of the product is sold* Business are able to maximise their share of the market demand* Fixed costs are more spread because more units are produced | * The extra output needs to be sold* The business needs to have spare capacity | * If the demand isn’t there then this is a risky option* There could be a rise in fixed costs* In the rush to make more units, the quality of the product could be reduced |
| Reduction of fixed costs | * By reducing fixed costs a business can enjoy higher profits* The break-even output is reduced* Massive savings can be had by getting rid of overheads which are unnecessary | * As long as the cost cuts don’t jeopardise the quality of the product or customer service* In general, savings can always be discovered in overheads | * It could lead to a reduction in a business’ ability to increase its sales* Intangible costs could be affected, for example redundancies leading to demotivation |