The Measurement and Importance of Profit The term profit comes from the Old French prufiter, porfiter, meaning to benefit. Throughout history, the notion of profit has always been a controversial subject. Indeed, its definition and explanation has never stopped to be questioned. From a business point of view, profit involves the risk-taking initiatives and the managerial functions of an enterprise. As seen earlier in this course, a business is an organisation engaged in the trade of goods, services, both to individual consumers and other businesses. Every business operates with the implied ultimate goal of making as much profit as possible. This course will help you answer exam questions; explain why profit is important and how to measure it. I. The Importance of Profit From a strict economic point of view, making profit is the first and most important objective of a business. Profit allows the company to survive and exist in the long run by reinvesting in multiple ways the surplus of wealth created. However, in a fast and highly competitive economic environment, a business must also focus on various objectives to satisfy both profit maximisation aims and mission related goals. The elements of the organisation targeted include its customers, employees, investors, environment, and reputation. Those parties do not necessarily have the same considerations regarding profit. It is in its best interest for a business
to pay attention to these factors as they have a great impact on its ability to create wealth over the long run. II. A Fundamental Variable Profit is the most important variable for most businesses not for profit organisations being excluded. Multiple aspects of the business depend on it, such as: Survival: In this highly competitive business world, an enterprise cannot expand or even survive in the long run if it does not generate enough wealth to exceed its total costs. Profit can be used to buy raw materials, pay essential bills like energy costs and natural resources, or pay wages. It also eases negotiations with banks as they are more willing to lend to a successful money-making business. Expansion: Businesses could grow or recede. Profit is a major factor if not the most important one. Once a business is profitable, it can reinvest retained earnings to increase the company s market share by launching new products and/or services through research and development (R&D), mergers acquisitions (M&A), and/or outsourcing. Indicator of efficiency: Efficient businesses have growing profit rates. Such dynamic is motivating for employees as it permits to maintain their jobs and get more value from it (higher monetary rewards, increased self-esteem, career development). Profit also attracts potential investors as they seek the less risky and most profitable opportunities to increase the return on their investments. Reward for risk-taken initiatives: Indeed, risk and reward are positively correlated in business. Reward represents the business s return on investment when it reduces risks and makes profit from its operations. The level of risk a company is willing to take depends greatly on its industry high tech firms more risky than firms dealing with
perishable goods for instance and on its strategic business plan as well. As a general rule, managers must keep in mind that most investors are risk averse; while in business, the higher the risks, the higher the returns expected. Emergencies capitals: In this case, profit is essential in order to meet future contingencies such as changing customer preferences, growing competition, changing government regulations, etc. All these changes are extra expenses for the business; expenses which should be evaluated by managers when creating contingency plans. III. Implications of Profit Though the main objective of most businesses is to make a profit, which is the primary measure of its success, modern economic systems suggest to not be focusing only on the profit maximisation theory. In fact, organisations want to achieve other goals as well in order to be in accordance with their vision and mission statements. These goals cover important considerations for doing business, such as: Industry authority: In order to become a leader in its industry, a business must either achieve tremendous sales volumes products and/or services and/or manufacture large quantities of goods. Being a leader implies for the business: to have a satisfactory profit level, which is consistent with its investment expenses, labour force employed and volume of output manufactured. Limiting competitors: When an enterprise produces enough profit to guarantee its survival and growth, a policy of restraining profit can be useful to limit competitors entrance into the market. Indeed, the more profitable a business is, the more competitors will try to invade the industry as they see untapped economic opportunities.
Political repercussions: Highly profitable businesses are more susceptible to be implied in the government affairs. Indeed, businesses with high profit tend to be monopolistic and sometimes the government may want to regulate it by tightening price-controls and anti-monopolistic policies. Wage considerations: High profit also implies to reconsider employees wages. Indeed, the more profitable a firm is, the more likely the public comes to know that it is paying higher dividends to shareholders and higher bonus to executives. Naturally, employees and associations would like an increase in their salaries. This is in the best interest of a business to satisfy those specific requests in order to keep a harmonious relationship between executives and employees without compromising the firm profit margin. Profit vs. Cash: Whereas profit is established when sales are made, cash flow represents the money a business has still available. Many organisations prefer to focus on liquidity maximisation as it is an indicator of efficiency for day to day transactions. Those businesses prefer to maintain higher liquidity and lower profit levels. Avoiding risks: Profit maximisation goals imply risky elements. Being involved in new ventures and expansions increases the number of uncertainties. For that reason, some businesses prefer to focus on loss avoidance rather than profit maximisation. IV. The Measurement of Profit Accounting standards are set out to ease the measurement and reporting of profit. When measuring profit, income and expenses arising from the business activities are directly connected. Profit is calculated by subtracting total costs from total revenue. Total Profit = Total Revenue Total Costs
When the value of profit is 0, the business is said to be at a break-even point; which corresponds to the situation where total costs variable and fixed perfectly match total revenue. The break-even point is often used by business owners to analyse at which point the business could become profitable considering the differences between fixed and variable costs. 1. Economic Profit vs. Accounting Profit There are two ways to calculate the performance of a company s financial assets: the accounting profit measurement or the economic one. Accounting profit: It must include the monetary excess of a business by subtracting total expenses from total income; considering realised or actual financial gains and losses. Accounting expenses include the assets spent by the business and any provision for losses or depreciation over a particular period of time. Accounting profit = Total income Total expenses The accounting profit takes into consideration: Leased assets generally an equipment, vehicle or software. The lessee will be able to use that asset for a specified period of time and will have to pay a rent to the lessor; Allowances often separated into a distinct account, it takes into account the amount of losses due to price reduction. In fact, when there is a problem of quality, delay or interruption, the seller lowers its price. The amount lost for the seller is computed in this section; Non-cash adjustments A cost which does not necessitate cash but which will lower earnings. For instance, if a company realises after acquiring it, that the true
value of another company s goodwill is lower, it will take a non cash charge amounting the value of the difference between the evaluated and actual goodwill value of the company acquired. This in turn will negatively affect the company s earnings. Provisions legal clause that could be included in a contract protecting one or several parties in the event of a particular situation. It could also prevent a party or several from performing a specified thing in a specified time. Transaction for depreciation related to the lost in value of plant and equipment. And development costs total expenses related to the developing of the business operations; they include categories such as research & development, plant and equipment, wages and many others, depending on the project s size and complexity. Economic profit: Unlike accounting profit, economic profit takes into consideration implicit costs including potential value of goods and/or services. Also called opportunity costs and explicit costs, they are monetary amounts directly paid, easily identified and quantified. Implicit costs include: Use of the firm own building: Being the owner of the business building properties is an implicit cost because rent is a tax deductible expense. Use of its own capital: Spending its own capital instead of borrowing from financial institutions may be viewed as a loss accounted as an opportunity cost. Use of the business owner s time for the production of goods and services: Investing time and money into the company s maintenance rather than working on the production processes and expansions can be considered as an implicit cost.
Explicit costs include: Wages: fixed and consistent payment for work or services; Materials: input necessary to create economic value; Rent: payment for the use of another entity s property; Other expenses such as energy costs. Economic Profit = Total Revenue Total Costs both Explicit and Implicit 2. Revenue For a company, revenue represents the total amount of money received for goods and services sold during a certain period of time often stated annually and quarterly. Revenue involves all net sales, exchange of assets, discount, and deductions for returned merchandises. It is the principal figure of a business s financial statements from which costs are subtracted to determine net income. In many countries today, businesses refer to revenue as turnover. 3. Fixed costs Fixed costs are those that remain constant whether the production volume changes or not. A few examples of fixed costs include: Rent of plant and equipment; Utilities fabrics and vehicles for instance; Salaries to employees and other contractors providing a work/service; Property taxes amount that could be easily computed and forecasted; Insurance to cover or limit damages in case of an unforeseeable and unwanted event;
Depreciation a decrease in value due to time, usage and external conditions such as the market; Amortisation the decreasing value of an asset spread over a period of time; 4. Variable costs Variable costs speak for expenses that vary in direct proportion to the output level of production. A few examples include: Raw materials that directly go into a product; Production supplies like machinery oil, electricity, water costs that vary with production volumes, Billable staff wages if employees are only paid on a variable hourly basis, Commissions to salespersons; Credit card fees Transporting and delivery costs when a business sells a product; freight can be considered as a variable cost when the company takes in charge the transportation and delivery expenses of the products it purchases. 5. Total costs Total costs represent all direct and indirect costs. They include variable costs which fluctuate according to the volumes of goods and services provided to customers, plus fixed costs which are independent from the production levels of goods and services. Finally, commissions and trading fees must also be included when calculating the total costs. Total costs = Fixed costs + Variable costs
To conclude, profit is an essential double-edged component for businesses. In fact, on one side, it is influenced by almost every aspects of conducting business while on the other side it impacts as much on its variables. It could vary according to its definitions or its associated terms such as benefit, net margin, earning, net income and so on. Developing and preserving profit is critical for the sustainability of any kind of business, it is what fuels it.
Multiple Choice Questions 1. What are the main reasons why profit is important? a. For survival and expansion; b. Reward risk taken initiatives; c. Emergency capitals and indicator of efficiency; d. All of them are correct. 2. Why businesses would like to limit their profit? a. To limit competitors' entry in the industry; b. Because of possible political repercussions; c. To reduce cash flow while reducing profit at the same time; d. (a) and (b). 3. Which statement is incorrect? a. Profit maximisation implies higher risks and uncertainty; b. Investors and shareholders satisfaction is the primary objective of a business; c. To become the leader in its industry, a business profit must be consistent with its expenses; d. Variable costs can be considered as opportunity costs. 4. Which statement(s) is (are) true? a. Economic Profit = Total Revenue Total Costs both Explicit and Implicit; b. Accounting profit = Total Expenses Total income; c. Accounting Profit = Total Revenue Total Costs both Explicit and Implicit; d. Total costs = Fixed costs Variable costs.
5. What is a break even in business terminology? a. It corresponds to higher revenues than costs; b. It corresponds to equal variable and fixed costs; c. It corresponds to equal revenues and costs; d. It represents a level of no profit. 6. What are the two ways to measure profit? a. Accounting and Economic profit; b. Variable and. Fixed profit; c. Accounting and Managerial profit; d. Investment and Economic profit. 7. Explicit costs include? a. Materials, salaries, rent, various expenses, and use of firm's own building, own capital, business owner's time; b. Materials, use of a business own capital, rent, and various expenses; c. Materials, salaries, rent, and various expenses; d. Use of firm's own building, own capital, and business owner's time. 8. Which one is included in variable costs? a. Commissions and credit card fees; b. Rent and property taxes; c. Electricity and water bills; d. (a) and (c). 9. Which statement is false? a. Government may want to regulate price to prevent monopolistic business activities;
b. Salaries is a fixed cost; c. Economic profit involves explicit and implicit costs; d. Fixed costs only includes explicit costs. 10. What does the term "profit" in Old French stand for? a. prufiter, porfiter, meaning to exchange; b. prufiter, porfiter, meaning to innovate"; c. prufiter, porfiter, meaning to benefit"; d. prufiter, porfiter, meaning to avoid risks". Answers 1: d ; 2: d ; 3: b ; 4: a ; 5: c & d ; 6: a ; 7: c ; 8: d ; 9: d ; 10: c ;