Profit – What Is It and How Does It Work?
Profit is possibly the most crucial concept in the entire capitalist economic model. It is at the heart of contemporary business and is one of the principal metrics of success in modern society. If your business doesn’t turn a profit, it’s not going to be around for long. For companies, profit is usually a matter of survival. Here, we take an in-depth look at what profit is and the different ways in which you can calculate it.
Used outside of a business environment, "profit" is taken to mean any advantage or benefit that can be realised by individuals or organisations. However, within a business context, it takes on a more specific meaning that is central to the modern economic model.
The Collins English Dictionary defines this type of profit as “an amount of money that you gain when you are paid more for something than it cost you to make, get, or do it.” Though this is somewhat of a generalised definition, it conveys a basic understanding of what profit is and how it is acquired.
However, if you take a more in-depth look at the profit definition, you'll discover that there are numerous different types of profit and just as many means of calculating it. To ensure you have a thorough understanding of what the term has come to encompass, we’ve provided working definitions of all the principal forms of profit.
Gross profit definition
Gross profit is the first type of profit we’ll look at and a jumping off point for our exploration of all other kinds of profit. It is calculated by subtracting the cost of goods sold or services rendered from a business’ sales. This means that it’s typically expressed as,
Total sales – Cost of goods sold or services rendered = Gross Profit
If a shoe company has 100 pairs of shoes that cost them £2 a pair to manufacture and they sell at £10 a go, they would make a total of £1,000 in sales on products that cost them a total of £200 to manufacture. Their gross profit calculation would look like this,
£1,000 - £200 = £800
This would mean that their gross profit is £800. This is also sometimes known as credit sales, or sales profit and is a useful indicator of the financial position of a business.
Operating profit definition
The second kind of profit is operating profit. To calculate operating profit, it’s necessary to take the gross profit calculation and deduct operating expenses. Operating expenses include all other services that don’t play a direct role in the manufacturing of a product or the provision of a service, such as marketing, sales, and customer service costs. Operating profit is expressed as:
Gross profit – Operating expenses = Operating profit
Using our previous shoe shop example, we can establish the operating profit by performing the following calculation. If we assume that the 100 pairs of shoes required £300 of operating expenses to get to market, advertise, and sell, we will discover that,
£800 - £300 = £500
This means that the shoe company would be generating an operating profit of £500. Operating profit is sometimes referred to as "earnings before interest and tax" (EBIT) and, although the calculation mentioned above is its most common form, some companies also decide to complicate it. For instance, some business may also take depreciation (a reduction in the value of a product or service over time) and amortisation (the write off of an asset over its entire useful life) into account. In this case, the formula would look like,
Gross profit – Operating expenses – depreciation – amortisation = Operating profit
This provides organisations with a more accurate representation of operating profit.
Net profit definition
Finally, net profit is possibly the most useful calculation and the most important type of profit. To calculate net profit, we begin with the operating profit and subtract all other expenses, such as taxes and interest. This means the calculation is expressed as,
Operating profit – All other expenses = Net profit
Total sales – Total expenses = Net profit
If we imagine that the shoe company has a 15% tax levied on its profits, we would have the following calculation to make,
£500 - £75 (15% of £500) = £425
This means that the shoe company makes a net profit of £425 after all operating expenses have been paid. Net profit is sometimes referred to as the "bottom line," as it's found on the last line of a company's balance sheet. It's an important figure because it's the value that determines the share value of a company. If a business is generating high net profits, this will push up share prices. Conversely, if a low net profit is posted, the share price is likely to plummet.
Making a margin
With all three types of profit, it’s possible to calculate a margin that gives us a clear indication of how the business is performing and whether it's in good health. Gross profit margin is calculated by dividing the gross profit figure by total sales. The operating profit margin is calculated by dividing operating profit by total sales and net profit margin by dividing net profit by total sales. In the case of our shoe shop, this would result in the following figures,
Gross profit margin: £800 / £1,000 = 80%
Operating profit margin: £500 / £1000 = 50%
Net profit margin: £425 / £1,000 = 42.5%
As you can see, the margin can change quite drastically between the different types of profit. This difference can help you identify where things can be improved in your business operations.
Economic profit vs accounting profit
It's also important to make a distinction between economic profit and accounting profit. Accounting profit is equivalent to net profit or a business' bottom line. On the other hand, economic profit factors in the cost of choosing one action over another. In this sense, it's a more abstract calculation that utilises economic theory to make assumptions about how much profit would have been made or lost, were another course of action taken.
>> Interested in knowing more? Have a look at our article on revenue.