Profit 3 lessons covering profit. We will look at: Calculation of: gross profit operating profit profit for the year (net profit) Statement of comprehensive income (profit and loss account) measuring profitability: calculation of gross profit margin, operating profit margin, and profit for the year (net profit) margin ways to improve profitability Distinction between profit and cash

Statement of comprehensive income All plcs (what are these?) must publish documents showing financial performance including a ‘statement of comprehensive income’ (also called a profit and loss account) Each type of profit is calculated after subtracting different types of costs Income Statement   £000 Revenue 1050 minus Cost of sales 500 equals Gross profit 550 Fixed overheads 250 Operating profit 300 Net financing costs 10 and Tax 60 Profit for the year (net profit) 230

Different types of profit Income Statement   £000 Revenue 1050 minus Cost of sales 500 equals Gross profit 550 Fixed overheads 250 Operating profit 300 Net financing costs 10 and Tax 60 Profit for the year (net profit) 230 Different types of profit Items Gross profit = revenue – cost of goods sold (variable costs) Operating profit = gross profit - fixed overheads (fixed costs) Net profit = operating profit – net financing costs (interest on loans) – taxes Look up Ted Baker’s financial accounts Take Ted Baker and put in this format

Revenues As before, P x Q Q3 2015 iPhone 47.5m times $660 = $31,400m!! Toyota selling 8.7m vehicles in 2013 at $25,000 = $217,000m Revenue recognised when ownership of the good has changed hands (not when cash is received)

Cost of sales – variable costs Raw material costs Toyota – steel, tyres, any materials/components they buy Tesco – cost of food or any product they sell Other direct costs Workers on the production line

Fixed overheads These are the overheads of the business ands are unrelated to the level of output Salaries, rent, utilities, marketing, insurance, administration costs

Cost of finance A loan of £10,000 with an interest rate of 10% will cost £1000 in interest during the first year If the loan includes some principal repayment, the interest charge will fall each year (as the principal gets smaller) If the loan has a lump-sum repayment at the end, the interest charge will stay the same each year

What makes a profit good? Is gross profit of £25 million good or bad? What about operating profit of £40,000? Cannot tell from this, because a bigger firm should make a higher profit than a smaller one Gross profit of £25 million for Starbucks would be disastrous, but an operating profit of £40,000 for Italian Taste is probably quite good! Should compare profits with revenues Called margins and are in %

Margins We can calculate margins from the income statement: gross profit margin is (gross profit/revenues) x 100 Operating profit margin is (operating profit/revenues) x 100. This is my favourite of the profit margins Net profit margin is simply (net profit/revenues) x 100 £000 Revenue 1050 Gross profit 550 Operating profit 300 Interest 10 Tax 60 Net profit 230 Gross profit margin Operating profit margin Net profit margin Calculate these ratios GPM =40% NPM is 25% or NPM2 is 12.5%

The value of calculating margins Once margins have been calculated, stakeholders (the management, investors etc) can analyse them and ask questions, such as: What has happened to a particular margin over the last year or several years? How do profit margins compare with competitors? Question: which companies will have high margins?

What is a good net profit margin? Depends on the industry Industries with high sales volumes can still make good profits with low net profit margins eg food retail. In this case 5% would be excellent Industries/firms selling luxury items often make higher profit margins. Gucci, Apple. Can easily make 20% or more Always compare with: Previous year or years, so higher is good With competitors, so higher is good

Calculations Firm Revenues (£000) Net profits (£000) Net profit margin 15,000 750 B 800 100 C 3,000 1,200 D 5,000 E 40,000,000 12,000,000

How to improve profits 1 Profits = revenues minus costs, so increase revenue or cut costs Cut costs. How? Cut variable costs – buy cheaper raw materials, or switch supplier. Also manage stocks and cut waste Cut fixed costs – reduce staff, find cheaper location, cut promotion/advertising Produce more efficiently – better technology

How to improve profits 2 But cutting costs can be problematic. Why? Cutting variable costs can mean lower quality, which can damage the brand, leading to lower demand and so lower revenue, which means profits might not be increased Cutting fixed costs. Need to be careful that the location is suitable – near customers, convenient for key employees. Cutting staff can be dangerous – need a minimum number, and customer service may be affected Improving technology may lower costs, but may also be expensive (and so might not lower costs). Technology doesn’t always work either!

How to improve profits 3 Improve revenues. Consider the marketing mix (product, promotion, place, price) Change the price Lower it if PED is high, so a cut in price will lead to a sharp increase in demand. Effective if there are many competitors Increase it if PED is low, so a price increase will not Change the product to make it more appealing Change promotion to make it better known (but this costs money) Improve distribution to make the product more available

How to improve profit margin Similar to improving profits, but in this case it means increasing profits relative to revenues Obvious way is to raise the price. Can then make more profit (contribution) per unit. But demand will fall, so it depends on PED. IF PED is high, an increase in price will raise profit per unit, but if the number of units falls a lot, profits could actually fall. Cut costs. As before. Reminder of formula Have to increase profit relative to revenue. Obvious way is to raise price. Can then make more profit per unit of the good. However, what if PED is high and demand falls If PED is high, then demand is sensitive to an increase in price, and falls a lot, so could actually reduce profits Could sell 1 unit with a high profit per unit, but no overall profits once fixed costs are taken off. Cut costs. As before as long as the quality is nor reduced

Difference between cash flow and profits You must not confuse them. They are not the same Easy to think revenues = cash coming in But not all revenues mean cash coming in (at that time) There are other reasons for cash inflow Also easy to think costs – cash going out But not all costs mean cash goes out (at that time) There are other reasons for cash going out

Cash vs revenues costs and profits Item Cash in or out Revenue or cost Cash Sale Cash in revenue Credit sale No cash in or out Bank loan neither Sale of an asset Selling shares to raise money Buying raw materials on credit cost Sale and leaseback