The Importance of Profit (Cambridge (CIE) O Level Business Studies)

An Introduction to Profit

• Most businesses have the main objective of making a profit

  • Profits help new businesses survive and break-even

  • It is a reward for risks taken by entrepreneurs and investors

  • For more established businesses, profits can enable long-term growth 

• The most simple formula for calculating profit is:

• Profit can be categorised into net profit and gross profit

  • Gross profit is the difference between the money received from selling goods or services and the cost of making or providing them

    • It is calculated using the formula

• Net profit is the difference between the gross profit and all of the other business expenses

  •  It is calculated using the formula

• Profit is the surplus that remains after business costs have been subtracted from the total sales revenue

  • If costs exceed revenue, the business makes a loss
    

Diagram: the process of making a Profit

• Profit can be increased using the following strategies

  • Increasing sales revenues

  • Reducing costs

  • A combination of increasing revenue and reducing costs

The Importance of Profit to Private Sector Businesses

• Profit is the financial reward that entrepreneurs receive in return for the risks they take

  • Business owners invest long hours, creativity, their own money, and effort to make a successful business

• Profit is a useful source of finance

  • E.g. Retained profit can be used to fund the purchase of assets, pay bills and invest in research and development

• Profit is an indicator of success

  • Increasing profitability suggests that a business is being run effectively and could be an attractive investment

  • Profit levels can be compared over time and with similar businesses to determine how well a business is performing

• Some public sector organisations, such as public corporations, can have the objective of making a profit

  • Although social objectives may be more important, such as serving the local community, profits can be reinvested back into services such as education and healthcare

  • These profits, known as surpluses, could also be used to improve quality and service efficiency 

• Social enterprises also need to make a profit to survive, as they often have similar objectives to grow so that they can fund their social objectives

The Difference Between Profit & Cash

• Profit and cash are different financial terminologies

  • Profit is calculated at a specific point in time

  • While a company may be in profit, they may lack cash as some customers may not actually have paid them yet

• Profit is the difference between revenue generated and total business costs during a specific period of time

  • Profit can be an important indicator of a company's financial health and long-term success, as it helps to assess the effectiveness of a company's operations

• Cash is measured by taking into account the full range of money flowing in and out of a business

  • This includes revenue from sales, operating expenses, investments, loans, and any other cash-related transactions

Diagram: profit vs cash flow

• A profitable business is likely to fail quickly if it does not have sufficient cash

  • Cash-poor businesses will struggle to pay suppliers, employees and operating expenses

  • This is called insolvency 

    • Lifestyle retailer Joules announced plans to liquidate in December 2022 as a result of cash-flow difficulties, despite making a profit of £2.6 million during the previous year