Profit is the reward to business owners for investing. In small companies, it’s paid directly as income. In corporations, it’s often paid in the form of dividends to shareholders. When expenses are higher than revenue, that’s called a “loss.” If a company suffers losses for too long, it goes bankrupt.
Types of Profit
Businesses use three types of profit to examine different areas of their companies. They are gross profit, operating profit, and net profit.
Gross Profit
Gross profit subtracts the cost of goods sold (COGS) from total sales. Variable costs are only those needed to produce each product, like assembly workers, materials, and fuel. It doesn’t include fixed costs, like plants, equipment, and the human resources department. Companies compare product lines to see which is most profitable.
Operating Profit
Operating profit includes both variable and fixed costs. Since it doesn’t include certain financial costs, it’s also commonly called “EBITDA.” That stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It’s the most commonly used, especially for service companies that don’t have products.
Net Profit
Net profit includes all costs. It’s the most accurate representation of how much money the business is making. On the other hand, it may be misleading. For example, if the company generates a lot of cash, and it’s invested in a rising stock market, it may look like it’s doing well. But it might just have a good finance department and not be making money on its core products. Companies analyze all three types of profit by using the profit margin. That’s the profit, whether gross, operating, or net, divided by the revenue. A high ratio means it generates a lot of profit for each revenue dollar. A low ratio means the company’s costs are eating into its profits. Ratios differ according to each industry. Profit margins allow investors to compare the success of large companies versus small ones. A large company will have a lot of profit due to its size. But a small company might have a higher margin, and be a better investment because it is more efficient. Margins also allow investors to compare a company over time. As the company grows, its profit will grow. But if it’s not becoming more efficient, its margin could fall.
Profit Formula
Profit is calculated by the following formula: π = R - C
Where π (the symbol for pi) = profitRevenue = Price (x)C = Fixed cost, such as cost for a building +Variable cost, such as the cost to produce each product (x) x = number of units.
For example, the profit for a kid selling lemonade might be: π = $20.00 - $15.00 = $5.00
R = $0.10 (Price for each cup) (200 cups) = $20.00C = $5.00 (for wood to build lemonade stand) + $.05 (for the cost of sugar and lemons per cup)(200 cups sold) = $5.00 + $10.00 = $15.00
Profit Motive
The purpose of most businesses is to increase profit and avoid losses. That is the driving force behind capitalism and the free market economy. The profit motive drives businesses to come up with creative new products and services. They then sell them to the most people. Most important, they must do it all in the most efficient manner possible. Most economists agree that the profit motive is the most efficient way to allocate economic resources. According to them, greed is good.
Two Foolproof Ways to Increase Profit
There are only two ways to increase profit.
Increase Revenue
Revenue can be increased by raising prices, increasing the number of customers, or expanding the number of products sold to each customer. Raising prices will increase revenue if there is enough demand. Customers must want the product enough to pay higher prices. Increasing the number of customers can be expensive. It requires more marketing and sales. Expanding the number of products sold to each customer is less expensive. The trick is to understand your customer well enough to know which related products they might want.
Cut Costs
Lowering costs is a good method up to a point. It makes a company more efficient and thus more competitive. Once costs are down, the business can reduce prices to steal business from its competitors. It can also use this efficiency to improve service and react more quickly. Companies that want to quickly increase profits will lay off workers. This is dangerous. Over time, the company will lose valuable skills and knowledge. If enough companies do this, it can lead to an economic downturn. There wouldn’t be enough workers earning good wages to drive demand. The same thing happens when businesses outsource jobs to low-cost countries.
How Profit Drives the Stock Market
Profits are also known as “earnings.” Public corporations that are listed on the stock market announce them every three months in quarterly reports. That occurs during earnings season. They also forecast future earnings. Earnings season significantly affects how the stock market does. If earnings are higher than forecast, the company’s stock price generally rises. If earnings are lower than expected, prices will generally drop. Earnings seasons are especially important to watch in the transition phases of the business cycle. If earnings improve better than expected after a trough, then the economy could be coming out of the recession. It’s headed into the expansion phase of the business cycle. Poor earnings reports could signal a recession.
