1. 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

2. 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

3. 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

4. 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)

5. 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

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

7. 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

8. 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 %

9. 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%

10. 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?

11. 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

12. 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

13. 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

14. 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!

15. 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

16. 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

17. 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

18. 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