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Gross Profit
The profits made by a business consist of the money that is left over once all of the expenses incurred in running the business have been paid. Businesses usually separate their costs into variable costs and fixed costs. This means that a business can calculate two different types of profit - gross profit and net profit.
Gross profit - Gross profit is the difference between the money received from selling goods and services and the cost of making or providing them. It ignores any fixed costs, or overheads, so it is useful in showing how much profit each product or service generates.
The money received from selling goods and services is sales revenue. The cost of making the goods or providing the services is called the cost of sales, since it reflects the variable costs directly related to production, such as raw materials.
Calculating gross profit
In order to calculate gross profit, a business will use the following formula:
Gross profit = sales revenue − cost of sales
Net Profit
Net profit is the difference between the amount of money received from selling goods and services and all of the costs incurred in order to make them. Net profit is often considered to be the more important profit figure, as it includes all of the fixed costs and other overheads that a business has to pay.
Net profit can be negative, which would indicate that a business has made a loss, since its costs are greater than its sales revenue.
Calculating net profit
In order to calculate net profit, a business will use the following formula:
Net profit = gross profit − other operating expenses and interest
Gross profit margin
The gross profit margin is the percentage of sales revenue that is left once the cost of sales has been paid. It tells a business how much gross profit is made for every pound of sales revenue received. For example, a gross profit margin of 75% means that every pound of sales provides 75 pence of gross profit.
Where a business is able to provide significant added value, then the gross profit margin will be higher. Examples include handmade goods and specialist services.
GPM = Gross PROFIT / SALES REVENUE * 100
Comparing gross profit margins over time can be useful for businesses. In the example above, the gross profit margin decreased despite the fact that the sales revenue tripled and gross profit doubled. This indicates that the cost of sales, which includes raw materials, increased faster than the business increased the price it charged its customers. This business might respond by increasing the price that it charges its customers or by negotiating lower prices for raw materials with its suppliers.
net profit margin
The net profit margin is the proportion of sales revenue that is left once all costs have been paid. It tells a business how much net profit is made for every pound of sales revenue received. For example, a net profit margin of 32% means that every pound of sales provides 32 pence of net profit.
In the same way that net profit is lower than gross profit, because it accounts for more costs, the net profit margin will be lower than the gross profit margin. In markets that are particularly competitive, such as the food retail market, net profit margins can be very small.
nPM = net PROFIT / SALES REVENUE * 100
Businesses can use the net profit margin to identify what is happening to their fixed costs. They can do this in two ways:
Comparing the net profit margin with the gross profit margin - By comparing the net profit margin with the gross profit margin for the same time period, a business can identify how significant its fixed costs, or overheads, are. For example, a business that has a gross profit margin of 50% and a net profit margin of 10% knows that for every pound of goods sold, 40 pence is used to pay fixed costs. This can then be used to identify whether there is any scope to reduce these fixed costs.
Comparing net profit margins over time - By comparing net profit margins over time, a business can identify what is happening to its costs. For example, a decrease in net profit margin indicates either that sales revenue has fallen faster than costs or that costs have increased faster than sales revenue.
AVERAGE RATE OF RETURN
Businesses often have to make investment decisions. This might involve deciding which piece of equipment or machinery to buy, or whether to move to bigger premises. Any investment is made in the hope that in return the business will see its profits increase.
Anything that can provide information about the potential size of the return from an investment decision can be helpful. This is because a business will know the return it could get from leaving the money it is going to invest in the bank, so it can compare this number with the estimate of the return it could get from investing the money instead. For example, if a business knows that it can gain 1% interest on money in its bank account, then any investment that would use that money should return more than 1% in profit. Otherwise, the business would be better off financially by leaving the money in the bank.
One calculation that can help a business to compare different investment options is the average rate of return.
Calculating the average rate of return
The average rate of return is a way of comparing the profitability of different choices over the expected life of an investment. To do this, it compares the average annual profit of an investment with the initial cost of the investment. This is necessary in order to compare investments that might last for different periods of time.
To calculate the average rate of return, a business will use the following formula:
AVERAGE RATE OF RETURN = AVERAGE ANNUAL PROFIT / COST OF INVESTMENT * 100
For example, a small local building business has decided to invest in a small excavator, since it will allow jobs to be completed more quickly and therefore more work to be completed.
The owner has identified the excavator that is most suitable, but needs to decide whether to invest in a brand new excavator or a used one. The used excavator may be less reliable and will need to be replaced after four years. The business knows the following:
Financial data
The financial position of a business is crucial to all decisions that it makes. Using financial information, a business should be able to identify what options it can afford when making decisions. This financial data can be used to forecast how decisions might affect the business’ cash flow and assess any impact on future profits.
The financial data that can help to inform business decisions includes:
Costs and revenues - A business should be aware of what is happening to its total costs and revenues, and how well it is able to control them. This makes it easier to forecast what might happen in the future.
Gross and net profit - Identifying what is happening to costs and revenues enables a business to calculate how this might affect both gross profit and net profit, using historical profit information.
Profit margins - Profit margins can be calculated and compared either to the business’ previous figures or to competitors’ figures. They can help a business to understand what is causing any change in its profit levels.
Cash flow - Businesses need access to cash in order to survive. Accurately forecasting the cash flow in and out of a business is crucial when deciding what a business can and cannot afford to do.
Break-even - Knowing the break-even point in the business’ output is important when making decisions about which products to make. It can help a business to avoid making unprofitable products.
Average rate of return - Whenever investment decisions are required, a business will want to compare the expected returns from the options available. Calculating the average rate of return for each project enables a business to do this. This helps the business to identify the most profitable options.
Benefits of using financial data
Making use of financial data often requires the use of percentages and percentage change calculations over time. This enables a business to see trends and make comparisons, which can be helpful when making decisions. In addition, this data can be useful when communicating with shareholders or potential lenders about the performance of a business.
Marketing data can provide a variety of quantitative and qualitative information. This data often comes from market research, which can be used to obtain both primary data and secondary data. All of this information can be invaluable when making business decisions.
Primary research data
Primary research can provide either qualitative or quantitative data. However, it can be a particularly useful way for a business to collect qualitative data, eg detailed information about what customers want and what affects their buying behaviour. A business can then use this information to make decisions about which products it should launch or what prices it should charge.
Secondary research data
Although secondary data can be either qualitative or quantitative, it is particularly useful for obtaining quantitative data about the market in which a business operates. For example, knowing the total value of sales in the market, or whether the market is growing or shrinking, can help a business to decide whether to invest further in existing products or whether to develop completely new products.
Secondary research can also provide data from internal sales figures or information on the market share of competitors.
Using marketing data
Marketing data can provide sales forecasts and promotional plans that may affect other areas of a business. For example, if a business is planning to promote a product, it will need to ensure that its production departments can cope with any anticipated increase in sales.
Market data
Market data refers to information about the characteristics that make up a particular market. It includes both economic and demographic factors. These factors may affect the behaviour of consumers within the market and the level of demand for products and services.
Economic factors
Economic factors relate to money and wealth. They include consumer incomes, exchange rates, interest rates, the inflation rate and unemployment rates.
Businesses must take any changes in these factors into account when making decisions, as they can affect the purchasing decisions that customers make and the conditions in which a business operates. For example, an increase in inflation may lead to higher costs for a business, which must then decide whether to pass on these higher costs to customers.
Demographic factors
Demography refers to the composition of the population. Demographic data is useful for business decision-making as it can tell businesses about changes in population size, migration and population structure.
For example, an ageing population, where the proportion of older people increases relative to the proportion of younger people, would influence the decisions made by a business that produces babywear, since it may expect sales to fall as a result.
Limitations of using financial data
Despite the benefits of financial data, there are significant limitations that business owners need to understand.
Financial data can only be used after it has been collected, meaning that it is always out of date. While it can give insights into how a business has performed, it cannot predict the future. Business owners must take this into consideration when using company accounts to make big decisions.
When making decisions, a business owner should ensure that they are using a sufficient time period of information and a wide range of sources. For example, comparing three years’ worth of financial data is better than using one year, as it enables a business owner to make more informed decisions. Additionally, understanding other information - such as market trends (via market research) and the activities of competitors - is essential and complements financial data.
Another limitation of financial data is the fact that statistics and data can be interpreted differently using different methods, which can lead to different conclusions being drawn. For example, ‘90 per cent of customers were satisfied with the service’ could be interpreted as ‘one in every ten customers is not satisfied with the service’.
The final limitation of using financial data is that it only shows how successful a business is in financial terms. Financial success is not the only indicator of business success, although to many businesses it is the most important. Some businesses judge their success in terms of their environmental impact or according to their ethical aims.
Understanding business performance
There are a number of ways to measure the performance of a business, including:
changes in costs
changes in revenue
gross profit
net profit
gross profit margin
net profit margin
Most of the information required to analyse the performance of a business is contained within its accounts. Particular care is required if this information is used to compare the performance of one business against another business. This is because different businesses might have different accounting periods, and they may also have different accounting policies. It is important that comparable data is used.
Even when analysing multiple sources of information from the same business, it is possible to interpret the performance of the business in different ways, depending on how the information is used.
Making business decisions
Businesses make decisions using the information that they have available. It is important to ensure that any information used is:
accurate
sufficient
up to date
Accurate
Information used to make decisions needs to be accurate and complete. Inaccurate or incomplete information is likely to lead to incorrect business decisions being made. The consequences of this could be serious, potentially leading to a business failing.
Sufficient
One set of data, particularly financial data, can be meaningless unless put into context. This might mean comparing it with historical data or data from similar businesses. This is particularly true for seasonal goods and services, such as ice cream, where comparing sales in the summer months against sales in the winter months would not give a realistic growth figure for the business.
Up to date
Information needs to be kept up to date to ensure that it remains relevant. It is not just the passing of time that makes information go out of date. Any significant changes in the market can make data less useful. For example, the emergence of a new competitor would make historical market share data less useful.
Other limitations
Even when the information used to make decisions is accurate, sufficient and up to date, the way that such information is used may have limitations. For example, the average rate of return is often used to help a business make decisions by comparing the profitability of different investment options. However, this technique does not consider the effects of inflation on the value of cash.
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