What is the difference between contribution and profit?

How to analyse profitability Objectives; Calculate and interpret the Gross Profit Margin and Operating Profit Margin Identify methods of improving profitability Recognise weaknesses in lowering quality and raising price to increase profitability

This profit, that profit and the other… Profit margin …a comparison of profit to sales revenue Gross Profit (loss)… the revenue (or deficit) left over after the initial cost of the item which has been sold is deducted Operating Profit (loss)… the profit (loss) left after other expenses (direct and indirect costs) have been deducted from Gross Profit

Which of the following businesses is performing the best? The Queen Victoria, Walford   £ From P&L account… Sales 600 Opening Stock 50 +Purchases 380 -Closing Stock 40 =Cost of Sales 390 Gross Profit 210 Expenses 120 Operating Profit 90 From Balance Sheet… Fixed Assets 470 Current Assets 140 -Current Liabilities Working Capital Net Assets 520 Long term Liabilities 300 Capital & Reserves 220 Capital Employed The Rovers Return, Weatherfield   £ From P&L account… Sales 750 Opening Stock 220 +Purchases 460 -Closing Stock 230 =Cost of Sales 450 Gross Profit 300 Expenses 140 Operating Profit 160 From Balance Sheet… Fixed Assets 400 Current Assets 100 -Current Liabilities 125 Working Capital -25 Net Assets 375 Long term Liabilities 50 Capital & Reserves 325 Capital Employed

Operating Profit Margin “The amount of profit a business / product generates after paying expenses, as a percentage of turnover…” Operating Profit x100% Sales Revenue e.g. JT Industries made a Operating Profit of £530,000 from Sales of £2.2m; £530,000 x100% £2.2m = 24.1% In this example, 24.1% of the average selling price is clear profit The higher the profit margin the better A falling Operating Profit Margin may suggest that the business is wasting money through unnecessary expenditure This can be improved by reducing costs whilst maintaining sales On it’s own this means NOTHING

The Queen Victoria, Walford The Rovers Return, Weatherfield So who has the better Gross Profit Margin? The Queen Victoria, Walford   £ From P&L account… Sales 600 Opening Stock 50 +Purchases 380 -Closing Stock 40 =Cost of Sales 390 Gross Profit 210 Expenses 120 Operating Profit 90 From Balance Sheet… Fixed Assets 470 Current Assets 140 -Current Liabilities Working Capital Net Assets 520 Long term Liabilities 300 Capital & Reserves 220 Capital Employed The Rovers Return, Weatherfield   £ From P&L account… Sales 750 Opening Stock 220 +Purchases 460 -Closing Stock 230 =Cost of Sales 450 Gross Profit 300 Expenses 140 Operating Profit 160 From Balance Sheet… Fixed Assets 400 Current Assets 100 -Current Liabilities 125 Working Capital -25 Net Assets 375 Long term Liabilities 50 Capital & Reserves 325 Capital Employed

The Queen Victoria, Walford The Rovers Return, Weatherfield So who has the better Operating Profit Margin? The Queen Victoria, Walford   £ From P&L account… Sales 600 Opening Stock 50 +Purchases 380 -Closing Stock 40 =Cost of Sales 390 Gross Profit 210 Expenses 120 Operating Profit 90 From Balance Sheet… Fixed Assets 470 Current Assets 140 -Current Liabilities Working Capital Net Assets 520 Long term Liabilities 300 Capital & Reserves 220 Capital Employed The Rovers Return, Weatherfield   £ From P&L account… Sales 750 Opening Stock 220 +Purchases 460 -Closing Stock 230 =Cost of Sales 450 Gross Profit 300 Expenses 140 Operating Profit 160 From Balance Sheet… Fixed Assets 400 Current Assets 100 -Current Liabilities 125 Working Capital -25 Net Assets 375 Long term Liabilities 50 Capital & Reserves 325 Capital Employed

OPM = Operating Profit x100% Who is doing ‘better’? GPM= Gross Profit x100% Sales Revenue OPM = Operating Profit x100% Sales Revenue Company Year Turnover Operating profit Gross profit BLOGG plc 2010 £47,238,000 £4,642,000 £22,438,000 2011 £57,859,000 £8,256,000 £29,597,000 ABAY plc £6,283,000 £269,000 £3,438,000 £4,092,000 £-1,165,000 £2,359,000 BLOGG plc; OPM: 2010= 9.8% 2011=14.3% GPM: 2010=47.5% 2011=51.2% ABAY plc; OPM: 2010=4.3% 2011=-28.5% GPM: 2010=54.7% 2011=57.7%

Why measure? Comparisons can be made between; Previous & Current Performance Own & Competitor Performance Progress can be tracked and monitored; Allows analysis of adverse changes Allows objectives to be set linked to performance Actions can be taken to improve performance

Lower costs will again mean bigger profit margins… Improving Profits (1)… This is essentially easy; reduce costs and increase revenues - but there is always a trade off here to consider… Method Rationale / method Potential Drawback Cutting Costs Lower costs will again mean bigger profit margins… Cheaper Supplier Bulk buy to gain economies of scale Cut staff wages / training Cheaper goods often equate to lower quality, which will have an impact on image and demand. Customers may expect cost saving to be passed on. Lower trained / motivated staff are less likely to be efficient / producing quality goods Raising Prices Higher contribution means that profit levels will be higher on existing sales Establish a USP Assumes price will not affect demand – this is rarely the case due to price elasticity of demand

Raising Prices – the reality The following items increase in price by 10%, what will happen to demand? Cigarettes A top of the range FORD Mondeo Petrol Apples

This ‘short-term’ view is common in the UK Improving Profits (2)… This is essentially easy; reduce costs and increase revenues - but there is always a trade off here to consider… Method Rationale / method Potential Drawback Increase Efficiency Reducing waste, will lower the costs per unit, improving ROCE (long-run) and OPM New machinery / systems Training (higher skilled and so less waste) Research & Development (to develop USPs’ and better methods of production) Higher Initial costs, which will mean that in the short-term at least investors will either need to invest more (actually reducing ROCE), or receive less of the profits back. This ‘short-term’ view is common in the UK

Rationalise capacity or product ranges Improving Profits (3)… This is essentially easy; reduce costs and increase revenues - but there is always a trade off here to consider… Method Rationale / method Potential Drawback Rationalise capacity or product ranges Sub-contract out excess capacity to other firms, or sell of assets to reduce costs and increase ROCE Sale of Assets Running at full capacity reduces fixed cost per unit Discontinue unprofitable lines By selling off capacity the business will actually reduce in size – not grow! Image and reputation may be adversely affected if lines or services are cut

Task Assessment activities (page 231) – questions 5-15