Profit and Loss

Profit as an Incentive

Profit: what is left when a firm's costs are taken away from its revenue. If costs are bigger than revenue, the firm makes a loss.

In a competitive market, profit is a signal to other firms. High profits → new firms are drawn in to share them, which is market entry → more supply → prices fall → profits are squeezed back towards normal profit. A busy new coffee shop soon has rivals opening nearby.

Normal profit: the smallest profit that keeps a firm in a market. It is just enough to cover the opportunity cost of the owner's time and money, which could be earning a return somewhere else. Profit above this draws new firms in; profit below it pushes firms out.

Losses work the other way. Firms that cannot cover their costs close or move into other markets, which is market exit → supply falls → prices rise → the firms that remain have a better chance of making a profit.

This is the incentive function of the price mechanism from unit 1.3.4. It only works if firms can get into the market: where barriers to entry are high, such as set-up costs or legal restrictions, existing firms can keep high profits for a long time.

Calculating Profit

Firms measure profit at three levels, each taking off another group of costs.

Gross profit: sales revenue minus cost of sales. Cost of sales is the direct cost of making or buying the goods that were sold, such as materials, stock bought in for resale and the wages of production staff.

Operating profit: gross profit minus other operating expenses. These are the costs of running the business that are not tied to each unit sold, such as rent, office salaries, marketing and utility bills.

Profit for the year: operating profit minus interest paid on the firm's loans. It is also called net profit.

The Statement of Comprehensive Income

Statement of comprehensive income: a financial statement that shows a firm's revenue, costs and profit over a period, usually a year. Its older name is the profit and loss account.

Here is a simplified statement for a bike shop's year. Each line of profit is the line above it minus the cost in between.

Figures in brackets are costs being taken away. If any profit line comes out negative, the firm has made a loss at that level, and it is shown in brackets too.

Measuring Profitability

A profit figure on its own does not tell you much: £40,000 is a good year for a bike shop but a disaster for a supermarket chain. Profit margins show profit as a percentage of revenue, so firms of different sizes can be compared:

\[ \text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100 \] \[ \text{Operating profit margin} = \frac{\text{Operating profit}}{\text{Revenue}} \times 100 \] \[ \text{Profit for the year margin} = \frac{\text{Profit for the year}}{\text{Revenue}} \times 100 \]

For the bike shop, the gross profit margin is 160,000 ÷ 400,000 × 100 = 40%, the operating profit margin is 50,000 ÷ 400,000 × 100 = 12.5% and the profit for the year margin is 40,000 ÷ 400,000 × 100 = 10%. So for every £1 of sales, the shop keeps 10p as profit.

Reading the margins together shows where the money goes. The gap between the gross and operating margins is overheads: here 27.5p of every £1. If that gap widens, overheads are rising faster than sales. The gap between the operating and profit for the year margins is the cost of the firm's debts.

How Firms Increase Profit

Profit is revenue minus costs, so there are two ways to raise it: bring in more revenue, or spend less.

Raising revenue:

• Raise the price: more revenue from each sale → higher profit, as long as customers keep buying. That is more likely when there are few close substitutes or the brand is strong. If many customers switch to rivals, revenue can fall.
• Sell more: advertising, new products, new outlets or selling online → higher sales volume → more revenue. Each of these has a cost of its own, so it adds to profit only if the extra revenue is bigger.

Cutting costs:

• Cheaper supplies: new suppliers or a better deal with the current ones → lower cost of sales → higher gross margin.
• Less waste: better use of staff and machines → each unit costs less to make → a higher margin on every sale.
• Lower overheads: smaller premises or less energy → lower operating expenses → higher operating margin.
• Cheaper borrowing: pay off expensive loans or replace them with cheaper ones → less interest → higher profit for the year.

Which option works best depends on:

• The side effects: cheaper materials can mean lower quality and unhappy customers, and cutting staff might lower costs this year but hurt customer service.
• The firm's market: a strong brand can raise its price, while a firm in a price-competitive market is more likely to have to cut costs.
• Time: cheaper supplies or lower overheads cut costs straight away, while new products and outlets take time to add sales.