This document discusses measuring and increasing profit. It defines key profit-related terms like profit, profitability, return on capital, net profit margin, and cash flow. It explains how to calculate profit and discusses ways to measure profit in absolute and relative terms. The document also provides various methods for businesses to improve profit, such as increasing sales volume or price, reducing variable or fixed costs, and increasing output. It notes the differences between profit and cash flow in terms of timing and accounting for fixed assets.

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

6. Example
Sales Costs Profit or Loss?
£100,000 £75,000 £25,000 (profit)
£100,000 £125,000 £25,000 (loss)
Total sales > total costs = Profit
Total costs > total sales = Loss
Total sales = total costs = 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 The percentage return
margin made on sales; calculated
as net profit divided by
sales

9. Net
Profit
Margin

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

11. Net Profit Margin – the formula
Net profit (before tax)
Net profit
= X 100
margin Sales
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
Company A Company B Company C
Example
£’000 £’000 £’000
Sales 150 250 500
Net profit 50 25 125
Net margin 20% 10% 25%

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

15. Return
On
Capital

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

17. Return on capital– the formula
Net profit (before tax)
Return on
= X 100
Capital Capital invested
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
less Variable Costs Reduce VC per unit
Increase output
less Fixed Costs
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  Depends on elasticity of demand
work?  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  Competitors are likely to respond
might not  Marketing efforts may fail – e.g. promotional campaign
work 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  Depends on price elasticity of demand
work?  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  Competitors are likely to respond (e.g. prices lower)
might not  Customers may decide to switch to competitors
work

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  Yes, if suppliers can be persuaded to offer better prices
work?  Yes, if quality can be improved through lower wastage
 Yes, if operations can be organised more efficiently
Why it  Lower input costs might mean lower quality inputs –
might not which can lead to greater wastage
work  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  Yes, if the extra output can be sold (e.g. finding a new
work? market, offering a lower price for a more basic product)
 Yes, if the business has spare capacity
Why it  A dangerous option – what if the demand is not there?
might not  Fixed costs might actually rise (e.g. stepped fixed costs)
work  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  Yes, provided costs cut don’t affect quality, customer
work? service or output
 A business can nearly always find savings in
overheads
Why it  Might reduce ability of business to increase sales
might not  Intangible costs – e.g. lower morale after making
work 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
less Variable Costs less Cash outflows
less Fixed Costs = Net Cash Flow
= 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 What happens What happens
Example to Profit? to Cash Flow?
Customer buys goods Sales of £50,000 are Cash inflow of £50,000
for £50,000 on 60 days recognised immediately when the customer
credit actually pays
Marketing campaign Cost of £10,000 Cash outflow of £10,000
costing £10,000 ordered included in marketing when the marketing
from marketing agency costs agency is paid
New factory machinery No effect. £150,000 Cash outflow of
bought for £150,000 added to the value of £150,000 paid to
fixed assets supplier of machinery
Depreciation charge of Depreciation of No effect on cash flow
£100,000 to reflect use £100,000 included as a
of factory fixed assets cost

31. Test Your Understanding
http://www.tutor2u.net/business/quiz/improvingprofit/quiz.html

32. Measuring and Increasing Profit