Profit

by Admin
Updated: June 22, 2018

Profit can be calculated in different ways using different methods and may even be unnecessary

A business must achieve two things: 1) It must survive, i.e. its cash flow must be sustained, and 2) it must produce a net return on investment (ROI). Provided that these conditions are met, the business does not need to deliver its profit at any particular time.

An operating profit can certainly enable a business to fulfill both conditions in a continuous way. However, if the business can grow in value and be sold for a large enough net positive return, an operating profit may even be unnecessary.

Costs

There are two main categories of cost. Precise definitions vary. The important thing is to understand the principles:

  1. Variable or direct costs which are directly proportional to sales. This would include things such as raw materials, i.e. doubling sales requires double the raw materials.
  2. Fixed or indirect costs, a.k.a. overheads which remain the same independent of the level of production. This would include things like rent.

Some costs can span more than one category:

  • A factory might require a certain amount of electricity to maintain functionality (a fixed cost) plus additional amounts as production is increased (a variable cost).
  • Financial/other costs such as depreciation and amortization may or may not be included in fixed costs.
  • Semi-variable costs are fixed while a certain range of conditions apply, e.g. adding workers, equipment etc as production increases.

Semi-variable costs can be particularly tricky: Once a business has reached a certain level of production, any further increase requires a disproportionate investment such as hiring another employee, buying/leasing additional machinery, moving to a bigger building etc. Fail to plan for this is quite common and it tends to get worse the business expands.

Income statement

A profit and loss (P&L) statement, a.k.a. an income statement shows the net difference between income earned and costs incurred over a certain period of time.

The way profit is calculated is related to the way costs are allocated:

  1. Gross profit, which is sales revenue minus the direct costs of generating those sales.
  2. Net operating profit, which is gross profit reduced by the overheads.
  3. Earnings after deduction of other costs.

Profit margin is the profit expressed as a percentage.

Accounting methods

There are two different accounting methods for deciding profit:

  • Accrual basis: Sales and expenses are included within the period they are applicable.
  • Cash basis: Sales and expenses are included within the period they are paid.

The accrual method is arguably most accurately reflective of the profitability of the business.

For example, if you obtain materials in January and convert them into invoiced sales in February you would want both the sales and the cost of the materials to apply to February.

If you bought the materials on trade credit and didn’t actually pay for them until March you would include them in February’s accounts as an “accrual.” Otherwise, it might look like you made an exceptional profit in February (sales without their costs) and an exceptional loss in March (costs without sales).

If you paid for the materials in January, you’d defer them to February as a “prepayment.” Otherwise, it might look like a loss in January.

The cash method can provide the advantages of simplicity and delaying tax liability when your costs are low or early. On this basis you deduct all your expenses as you pay them and only include receipts when they’re in the bank.

The cash method is usually the best choice for small businesses and startups, however, above relatively low turnover levels it is not a permitted option in most jurisdictions.

Warning: The fewer and shorter the periods, the easier it is for the income statement to be misleading regardless of basis.

Value

It is a common misconception that the primary purpose of a business is to generate a year-on-year operating profit.

While this can be true, substantial gains so often come from the eventual sale of the business (or some aspect of it) that it can be a perfectly viable proposition to never generate an income at all.*

An obvious example is data, when you launch an app and cultivate millions of users but are unable to monetize it yourself.

* The rules regarding losses can be complicated so, if you plan to report a year-on-year loss, it’s especially important to talk to a good accountant before you start.

Whether or not the eventual exit strategy is a capital gain, it is always good policy to focus on building value.

More info

The standard approach - understanding sustainable profitability - is presented with an agricultural example at iastate.edu

aderant.com notes that sometimes businesses simply assume greater revenue means greater profitability and focus on that instead (because it’s easier for firms to calculate).

Amazon was founded in 1994 and didn’t show a profit until 2001 (ibtimes.com). Although it has moved into profit in recent years (wired.com), its profit margin is still very low (ycharts.com).

As reported on barrons.com, Snap Inc. doesn’t even care about breaking even.

A customer-centric approach to profitability is described by Richard Barrett on anaplan.com

Internal links

Break-even Cash flow Pareto distribution Go to Articles
Agree? Disagree? Questions? Answers?
Please post a comment...
Log in