1. Measuring and Increasing Profit

2. What this topic is all about
What is profit (a recap from Unit 1)
Profit & profitability
Return on capital
Ways to improve profit
The difference between profit and cash flow

3. Unit 1 Reminder – What is Profit?
Profit is the
reward or return for taking risks & making investments

4. Profit as an Objective
For most businesses, making a profit is a key objective
Profit is the most important source of cash flow & finance for a business
Remember that there can be reasons for running a business other than the “profit motive”

5. Total Sales Total Costs Profit (or Loss)
Calculating Profit
Total Sales
less
Total Costs =
Profit (or Loss)

6. Example £100,000 £75,000 £25,000 (profit) £125,000 £25,000 (loss)
Sales
Costs
Profit or Loss?
£100,000
£75,000
£25,000 (profit)
£125,000
£25,000 (loss)
Total sales > total costs
Total costs > total sales
Total sales = total costs
= Profit
= Loss
= Break-even

7. Two Ways of Measuring Profit
Profit in absolute terms
The £ value of profits earned
E.g. £50,000 profit made in the year
Profit in relative terms
The profit earned as a proportion of sales achieved or investment made
E.g. £50,000 profit from £500,000 of sales is a profit margin of 10%
E.g. £50,000 profit from an investment of £1 million = a 5% return on investment

8. Two Key Terms to Remember
Capital
The amount invested into a business or project
Net profit margin
The percentage return made on sales; calculated as net profit divided by sales

9. Net
Profit
Margin

10. Net Profit Margin – What is Net Profit?
Net profit is what is left after all the costs of a business have been taken from its sales revenue
Example
£’000
Sales
150
Wages
(50)
Energy costs
(25)
Marketing
(15)
Other overheads
(30)
NET PROFIT 30
Net profit margin
20%

11. Net Profit Margin – the formula=
Net profit (before tax)
Sales
X 100
Note: net profit margin is expressed as a percentage

12. What does Net Profit Margin tell us?
How effectively a business turns its sales into profit
How efficiently a business is run
Whether a business is able to “add value” during the production process (a high margin business must be doing something right!)

13. The Importance of Comparison (1)
The net profit margin of a business should be compared with other competitors in the same market, and over time
Example
Company A
£’000
Company B
Company C
Sales
150
250
500
Net profit 50 25
125
Net margin
20%
10%
25%

14. The Importance of Comparison (2)
Example
Company A
£’000
Company B
Company C
Sales
150
250
500
Net profit 50 25
125
Net margin
20%
10%
25%
Company A makes a higher net profit than Company B even though its sales are lower – because it has a higher net profit margin
Company C makes the highest net margin of these three & also the highest sales. So it makes the largest net profit too

15. Return On
Capital

16. What is Capital? Capital is the amount invested in a business
Return on capital is the percentage return on that investment
Example
£’000
Net profit
200
Capital
2,500
Return on Capital 8%

17. Return on capital– the formula=
Net profit (before tax)
Capital invested
X 100
Note: return on capital is expressed as a percentage

18. What does Return on Capital tell us?
A measure of the returns made from investing in the business
How good is the business at converting money invested into profit?
Provides a means of comparison with other investment opportunities
Opportunity cost (remember from Unit 1!) – what an investor could have done by investing elsewhere

19. Methods of Improving Profits

20. The Basics of Increasing Profits
Increase quantity sold
Sales
Increase selling price
Variable Costs
less
Reduce VC per unit
Increase output
Fixed Costs
less
Reduce fixed costs
Net Profit =

21. Increase quantity sold
Why?
Higher sales volumes = higher sales, assuming that the selling price is not lowered
Makes better use of production capacity (i.e. fixed costs should not rise)
May result in higher market share
Will it work?
Depends on elasticity of demand
Sales value may actually fall if price has to be reduced to achieve higher sales volumes
Does business have capacity to sell more?
Why it might not work
Competitors are likely to respond
Marketing efforts may fail – e.g. promotional campaign does not generate results
Fixed costs might actually rise – e.g. higher marketing

22. Increase selling price
Why?
Higher selling price = higher sales (assuming quantity sold does not fall in response)
Maximises value extracted from customers
Customers may perceive product as higher quality
No need for extra production capacity
Will it work?
Depends on price elasticity of demand
Sales value may actually fall price rise is matched by an even bigger fall in quantity sold
It will work if customers remain loyal and still perceive product to be good value
Why it might not work
Competitors are likely to respond (e.g. prices lower)
Customers may decide to switch to competitors

23. Reduce variable costs per unit
Why?
Increase the value added per unit sold
Higher profit margin on each item produced and sold
Customers do not notice a change in price
Will it work?
Yes, if suppliers can be persuaded to offer better prices
Yes, if quality can be improved through lower wastage
Yes, if operations can be organised more efficiently
Why it might not work
Lower input costs might mean lower quality inputs – which can lead to greater wastage
Customers may notice a decrease in product quality

24. Increase output Why? Provides greater quantity of product to be sold
Enables business to maximise share of market demand
Spreads fixed costs over a greater number of units
Will it work?
Yes, if the extra output can be sold (e.g. finding a new market, offering a lower price for a more basic product)
Yes, if the business has spare capacity
Why it might not work
A dangerous option – what if the demand is not there?
Fixed costs might actually rise (e.g. stepped fixed costs)
Production quality might be compromised (lowered) in the rush to produce more

25. Reduce fixed costs
Why?
A drop in fixed costs translates directly into higher profits
Reduces the break-even output
Often substantial savings to be made by cutting unnecessary overheads
Will it work?
Yes, provided costs cut don’t affect quality, customer service or output
A business can nearly always find savings in overheads
Why it might not work
Might reduce ability of business to increase sales
Intangible costs – e.g. lower morale after making redundancies

26. Some more complex approaches
Reduce product range
Business often has too many products = complex operations & inefficiency
Some products may be very low-margin or even loss-making
Outsource non-essential functions
A way of reducing fixed costs
Focus the business on what it is good at
Areas to outsource: e.g. IT, call handling, finance

27. Difference between profit and cash flow

28. Two Different Concepts
What is Profit?
What is Cash Flow?
Sales
Cash Inflows
Variable Costs
Cash outflows
less
less
Fixed Costs
Net Cash Flow
less =
Net Profit =

29. Where cash flow differs from profit
Timing differences
Sales to customers made on credit
Payments to suppliers
The way that fixed assets are accounted for
Payment for fixed asset = cash outflow
Cost of fixed asset = treated as an asset not a cost
Depreciation is charged as cost when the value of fixed assets is reduced

30. Some examples Transaction Example What happens to Profit?
to Cash Flow?
Customer buys goods for £50,000 on 60 days credit
Sales of £50,000 are recognised immediately
Cash inflow of £50,000 ONLY when the customer actually pays
Marketing campaign costing £10,000 ordered from marketing agency
Cost of £10,000 included in marketing costs
Cash outflow of £10,000 when the marketing agency is paid
New factory machinery bought for £150,000
No effect. £150,000 added to the value of fixed assets
Cash outflow of £150,000 paid to supplier of machinery
Depreciation charge of £100,000 to reflect use of factory fixed assets
Depreciation of £100,000 included as a cost
No effect on cash flow

31. Test Your Understanding

32. Measuring and Increasing Profit