DRAFT. 34 Profit. Key points

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1 Key points 34 Profit 1. Calculation of gross profit, operating profit and net profit. 2. Statement of comprehensive income (profit and loss account). 3. Measuring profitability calculation of gross, operating and net. 4. Ways to improve profitability. 5. Distinction between cash and profit. Getting started Halfords is the UK s leading retailer of automotive and cycling products. It is also the main operator in garage servicing and auto repair in the UK. In it was reported that the business made a profit after tax of 55.5 million on a turnover of million. This was an increase on when turnover was million and profit after tax was 52.7 million. The sales of cycles did particularly well during the year, rising by 21 per cent. Calculate the percentage change in turnover between and. Calculate the percentage change in profit between and. What might account for the differences in these percentages? What measures might Halfords take to improve its profitability in the future? Source: Adapted from and www. telegraph.co.uk Profit As explained in unit ** if total costs are subtracted from total revenue you arrive at a business s profit. This is the money left over after all costs have been met, and belongs to the owners of the business. Accountants calculate and define profit in a number of ways. Gross profit: Gross profit is the difference between turnover and cost of sales., also called revenue or sales revenue, can be calculated as price quantity of sales. Cost of sales are the direct costs of a business. Gross profit is the profit made by a business after direct costs have been met. For a retailer or wholesaler the cost of sales is the cost of buying in stock to re-sell. For a manufacturer the cost of sales is any costs associated directly with production, such as raw materials, factory wages and other direct costs. For a supplier of services it is any direct costs, such as direct labour. Gross profit is calculated by: Theme 2 Operating profit: Operating profit is the difference between gross profit and business overheads. Overheads are indirect costs, such as selling and administrative expenses. Operating profit is calculated by: Operating profit = Gross profit Operating expenses Net profit (profit for year): Net profit or profit for year is the profit made by the business for the year. It is the difference between operating profit and interest and any other exceptional costs. Net profit may be calculated before or after the subtraction of taxation. It is calculated by: Net profit = Operating profit Interest (and any exceptional items) Sometimes net interest is shown in the income statement. This is the difference between any interest paid by a business (on loans and overdrafts for example) and any interest received by the business (from money placed in deposit accounts, for example). Worked example HLD plc is a large paper-manufacturer. In its turnover was 46 million. Its cost of sales was 23.5 million, operating expenses 12.4 million and interest paid 2.1 million. What was the gross profit, operating profit and net profit? Gross profit = Cost of sales = 46 million 23.5 million = 22.5 million Operating profit = Gross profit Operating expenses = 22.5 million 12.4 million = 10.1 million Net profit = Operating profit Interest (and any exceptional items) = 10.1 million 2.1 million = 8 million Gross profit = Cost of sales Exam Tip You need to remember that when calculating profit that the answer can be negative. This means that a loss has been made. 12

2 Question 1 Weston Manor Hotel is an established and successful fourstar hotel in Somerset. It has 43 rooms, employs 42 staff and its restaurant has a reputation for fine dining. Some financial information for the hotel for and is shown in Table 1. Table 1 Financial information for Weston Manor Hotel 2,341,700 2,600,700 Cost of sales 1,090, ,500 Administration expenses 399, ,900 Interest 21,000 19,300 (a) Calculate: (i) gross profit, (ii) operating profit, (iii) net profit for and. (b) Calculate the percentage change in net profit between and. (c) Assess whether the financial performance of the hotel has improved over the two years. Statement of income (profit and loss account) At the end of the trading year businesses produce documents that show key information relating to the financial performance of the business. One of these documents is the income statement. This shows the income and expenses of a business during the financial year. It is used to calculate gross profit, operating profit and net profit. The layout of the statement is important. The financial information must be presented in a standard way. An example of an income statement for Forest Way Autotraders Ltd, a second-hand car dealership, is shown in Table 2. Table 2 Income statement for Forest Way Autotraders Ltd for the year ending ( ) ( ) 561, ,200 Cost of sales 331, ,100 Gross profit 230, ,100 Selling expenses 45,300 38,200 Admin. expenses 122, ,800 Operating profit 62,200 35,100 Interest 22,100 21,000 Net profit 40,100 14,100 Taxation 8,000 2,800 Net profit after taxation 32,100 11,300 The income statement always shows the figures for the current trading year and the previous year. This allows a comparison to be made. In this case, the income statement shows that net profit before tax has increased from 14,100 to 40,100. This is a significant increase. The statement in Table 1 also shows the taxation paid by the business and the net profit after tax. Income statements are discussed in more detail in Unit??. Question 2 Managing business activities AppGame Ltd is a new, but growing, company. It designs children s game apps on mobile phones. During the company had some staff shortages and invested in an expensive recruitment campaign. The income statement for AppGame Ltd is shown in Table 3 (three figures are missing). Table 3 Income statement for AppGame Ltd, year ending Cost of sales Gross profit? Selling expenses Admin expenses? Operating profit Interest? Net profit Taxation Net profit after taxation (a) What is meant by an income statement? (b) Calculate the missing figures in the income statement for AppGame Ltd. (c) Assess the possible impact on AppGame Ltd of the staff shortages in. Measuring profitability The information contained in the income statement can show how well a business is performing. For example, in Table 2 the income statement for Forest Way Autotraders Ltd shows that net profit for the year has increased from 14,100 to 40,100. This is a significant increase. However, it is possible to measure the profitability of a business in a more meaningful way. This can be done by calculating s, which measure the size of profit in relation to turnover. Three s can be calculated. Gross : The gross is also known as the mark-up. This shows the gross profit made on sales turnover. It is calculated using the formula: Gross profit Gross = 100 Higher gross margins are usually preferable to lower ones. It may be possible to increase the gross by raising turnover relative to the cost of sales, for example by increasing price. Alternatively, the cost of sales could be reduced relative to turnover. However, the gross required will tend to be different for different industries. As a rule, the quicker the turnover of stock, the lower the gross margin that is needed. So, for example, a supermarket with a fast stock turnover is likely to have a lower gross margin than a car retailer with a much slower stock turnover. Some supermarkets are therefore very successful with relatively low gross s because of the regular and fast turnover of stock. 13

3 Profit Unit 34 Operating : The operating shows the operating profit made on sales turnover. Operating margin is used to measure a company s pricing strategy and operating efficiency. It gives an idea of how much a company makes (before interest and taxes) on each pound of sales. It is calculated using the formula: Operating profit Operating = 100 A high or increasing operating margin is preferred. If the operating margin is increasing, the company is earning more per pound of sales. Operating margin shows the profitability of sales resulting from regular business. Operating income results from ordinary business operations and excludes other revenue or losses, exceptional items, interest and income taxes. Net : The net takes into account all business costs, including interest, other non-operating costs and exceptional items. It is also usually calculated after tax has been deducted. The net can be calculated by: Net profit after tax Net = 100 Again, higher margins are usually better than lower ones. The net focuses on the so-called bottom line in business. The bottom line refers to the very last line in the income statement, which shows the profit left after all deductions have been made. It is the final amount of profit left over for the owners. 14 Worked example Table 2 shows the income statement for Forest Way Autotraders Ltd. The s for can be calculated as follows. Gross Profit 230,000 Gross = 100 = 100 = 41% Operating profit 62,200 Operating = 100 = = 11.1% (Net profit (after tax) 32,100 Net = 100 = = 5.7% Table 4 provides a summary of the s for both and. Over the two years there is a clear improvement in all of the s. This suggests that the business has performed well improving efficiency and possibly raising prices. Table 4 Profit margins for Forest Way Autotraders Ltd and Gross 40% 35.3% Operating 11.1% 7% Net 5.7% 2.3% Exam Tip Calculating the different s is fairly straightforward. It is important, though, to interpret the answers correctly. You need to know that the gross margin will always be the highest and the net margin the lowest. You also need to know that higher margins are better and that an increase in margins over time shows an improvement. Profit margins can be used to make comparisons between businesses in the same industry, but only if the businesses being compared have similar trading activities. For example, using the gross margin to compare the performance of Sainsbury and Marks and Spencer may not be appropriate because many of their product lines and the proportions of types of retail product are different (M&S sell more clothes than Sainsbury, for instance). You need to understand that s are likely to vary considerably across different industries. Question 2 Chapperton Ltd develops wearable technology. UK shoppers spent around 105 million on wearable tech devices during the Christmas shopping period in, a massive increase of 182 per cent compared to the previous year. Fitness and activity trackers are the most popular wearable devices, accounting for over 29 million, followed by smart watches at 25 million and healthcare wearable devices at 22 million. Table 5 Income statement for Chapperton Ltd, s 000s 7,800 5,700 Cost of sales 3,780 2,100 Gross profit 4,020 3,600 Admin expenses 1,560 1,800 Operating profit 2,460 1,800 Interest Net profit 2,390 1,755 Taxation Net profit after tax 1,810 1,305 (a) Explain the difference between the gross and the net. (b) Calculate the gross, operating and net s for and. Present the information in a table. (c) Assess the financial performance of Chapperton Ltd in.

4 Ways to improve profitability All businesses will want to improve their performance. An improved performance is likely to benefit all stakeholders. The returns on capital can be increased by making more profit with the same level of investment. This might be achieved by growth funded externally. This means the business increases sales using fresh capital. Increasing s will also improve performance. If s can be raised, the business will make more profit at the existing level of sales. The s can be improved in two ways. Raising prices If a business raises its price it will get more revenue for every unit sold. If costs remain the same then profitability should improve. However, raising price might have an impact on the level of sales. Generally, when price is raised demand will fall. However, if demand is not too responsive to changes in price, the increase in price will generate more revenue even though fewer units are sold. Raising price is always risky because it is never certain how competitors will react. Lowering costs A business can also raise s by lowering its costs. It can do this by buying cheaper resources or using the existing resources more effectively. Using existing resources more efficiently. It might be possible to buy raw materials and components from new suppliers that offer better prices. It may also be possible to find new providers of essential services such as telecommunications, electricity, insurance and IT support. For example, there has been increased competition recently in the supply of gas, electricity and telecommunications. Another option might be to find ways of using cheaper labour. For example, some businesses have moved overseas to take advantage of cheap labour in places like China and eastern Europe. However, these measures may have drawbacks. When taking on new suppliers the possibility that they are cheaper because they are not as good should be considered. The quality of raw materials might be inferior, they may be unreliable and supply might not be guaranteed. For example, a number of new, and cheaper, broadband providers have not been able to guarantee supply. Moving abroad to take advantage of cheap labour may be disruptive. It may also damage the image of the company if it lays off large numbers of staff in the UK. Consequently, when looking to acquire cheaper resources, a business must be cautious and understand the pitfalls. Buying cheaper resources. Making better use of current resources will improve efficiency and lower costs. Managing business activities A business might do this by introducing new working practices or training staff. This would help to raise labour productivity. It could upgrade its machinery by acquiring newer, more efficient models. This would raise capital productivity. A business might be able to reduce waste by recycling materials, for example. Some of these measures might also have drawbacks. For example, the workers might resist new working practices and new technology often has teething problems. This could disrupt the business. Distinction between cash and profit It is important for businesses to recognise the difference between cash and profit. At the end of a trading year it is unlikely that the value of profit will be the same as the cash balance. Differences between cash and profit can arise for a number of reasons. During the trading year a business might sell 200,000 worth of goods with total costs of 160,000. Its profit would be 40,000. However, if some goods had been sold on credit, payment by certain customers may not yet have been received. If 12,000 was still owing, the amount of cash the business had would be 28,000 ( 40,000-12,000). Thus, profit is greater than cash. A business may receive cash at the beginning of the trading year from sales made in the previous year. This would increase the cash balance, but would not affect profit. In addition, the business may buy resources from suppliers and not pay for them until the next trading year. As a result its trading costs will not be the same as cash paid out. Sometimes the owners might introduce more cash into the business. This will increase the cash balance, but will have no effect on the profit made. This is because the introduction of capital is not treated as business revenue in the profit and loss account. The effect will be the same if a business borrows money from a bank. Purchases of fixed assets will reduce cash balances, but will have no effect on the profit a company makes. This is because the purchase of assets is not treated as a business cost in the profit and loss account. Sales of fixed assets will increase cash balances but will have no effect on profit unless a profit or loss is made on disposal of the asset. This is because the cash from the sale of a fixed asset is not included in business turnover. The amount of cash at the end of the year will be different from profit because at the beginning of the year the cash balance is unlikely to be zero. If, at the beginning of the year, the cash balance for a business is 23,000, then the amount of cash a business has at the end of the year will exceed profit by 23,

5 Profit Unit Case study FENNER Hull-based Fenner plc is a world leader in reinforced polymer technology. It employs over 5,000 people and serves markets in the US, Canada, Chile, Europe, Australia, Middle East, Africa, India and China. Since 2009 the company has grown its revenue by around 64 per cent. However, in revenue actually fell a little. This may have been due to slower than expected economic growth in emerging markets, such as China and India. In, it was reported in the media that Fenner plc was likely to experience a further reduction in turnover and profits. This was due mainly to a slowdown in demand for the mining conveyor machines they produce. As a result, staff at the firm s Marfleet Lane factory were put on a shorter working week for much of the year. In November Fenner s chief executive officer reported that in a climate of increased political and economic uncertainties, it was anticipated that the resilience and strength of the business would mean that growth in profitability and revenue would be likely to be offset by weakness in the mining market. (a) Calculate the gross for Fenner plc in and (4 marks) (b) Calculate the net for Fenner plc in and (4 marks) Key terms Amortisation the writing off of an intangible asset. Cost of sales the direct costs of a business. Exceptional costs a one-off cost, such as a large bad debt. Gross profit the difference between turnover and cost of sales. Gross or mark-up gross profit expressed as a percentage of turnover. Income statement a financial document showing a company s income and expenditure over a particular time period, usually one year. Net profit or profit for year the difference between operating profit and interest and exceptional items. Net net profit after tax, expressed as a percentage of turnover. Operating profit the difference between gross profit and business overheads, such as selling and administrative expenses. Operating operating profit expressed as a percentage of turnover. the total income of a business resulting from sales of goods or services. Table 6 Fenner plc income statement year ending Cost of sales Gross profit Distribution costs Admin. expenses Operating profit* Net interest* Net profit Taxation Net profit after taxation Operating profit* (after amortisation of costs resulting from acquisitions) Net interest* = Interest Paid Interest Received. Source: adapted from and co.uk (c) Assess the impact on Fenner plc of difficult global trading conditions. (8 marks) (d) Discuss the measures a company like Fenner plc might take to improve profitability. (12 marks) Knowledge check 1. How is gross profit calculated? 2. If operating profit is 32 million and interest is 670,000, what is the net profit? 3. What is meant by the bottom line? 4. What does an income statement show? 5. What does the operating measure? 6. What is the net if turnover is 128,000 and net profit is 18,000? 7. State two ways a business might increase its gross profit margin. 8. State two ways a business might lower its costs. 9. Describe briefly the difference between cash and profit. 10. State two reasons why profit may be higher than cash.