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What Is Profit?

By Paul Michael
16th October, 2009

 

Let’s imagine a simple shop that sells things. It buys things from any number of suppliers, puts those things onto its shelves and customers walk into the shop and buy things. Simple!
 
Everything that is sold to a customer is said to be ‘turnover’ or ‘sales’ and each thing has its price – what the customer pays. Every thing that we buy and subsequently sell is said to be a ‘cost’ or ‘cost of sales’. If we sell just one thing priced at £100, for which its cost is £50, we have a turnover of £100 and our cost of sales is £50. The difference yields our ‘gross profit’ of £50. Often the gross profit is expressed as a percentage, which in this case equates to 50%.
 
If we buy stock that it isn’t sold, the cost of these items remains as stock. Only when sold do the costs become ‘cost of sales’.
 
If we stock lots of things with varying prices and varying costs we might need spreadsheets or accounting software to help determine our turnover and our cost of sales. Especially for shops, we will need to determine the value of the stock at the beginning and end of our accounting or reporting period so that we can determine what we have spent on stock that has actually been sold.
 
At the end of our accounting or reporting period we have generated roughly £60,000 of sales and the things we sold cost us roughly £24,000. So we have made a gross profit of 60%. There is something else we can deduce from this: we have subtracted the cost of sales from the turnover, leaving £36,000, and that is 60% of the turnover. This means that the cost of sales is the remaining 40% of our sales. This is a useful percentage to remember to keep within a stock replacement budget: for each £100 we sell, we should spend about £40 replacing it.
 
Now we have our gross profit and out cost of sales. What about other expenses we need to pay. We have our rent, insurances, staff costs, energy, water, telephone and advertising expenses, just to name a few. The gross profit contributes to these expenses and, for that reason, is sometimes known as the ‘contribution’, expressed as a value; £36,000 in our example.
 
Let’s assume that all of our expenses for the reporting period amount to £24,000. This will leave us £12,000. As a percentage of our turnover this is 20%. So we have a net profit of 20%.
 
With this information we can now determine one or more break-even values. Many small businesses determine net profit as that which can be drawn down and used by the business owner. Corporations on the other hand, pay all of their staff and directors and consider net profit as what is left. So, the small business might want to know what turnover must be achieved to pay all of its liabilities. It then might want a break-even value that will pay a comfortable wage. Let’s do a break-even that yields zero profit.
 
Generally speaking, the expenses in a shop remain the same month-on-month. That is, they are fixed. The cost of sales, however, is a variable value and is dependant upon what is sold. In our shop we know that we require a contribution of £24,000 to pay for our expenses. We know that the contribution makes up 60% of the turnover that we need. So 24k divided by turnover is equal to 60% (or 0.6). Or 24k / 0.6 = 40k.
 
The triangle trick can be used for equations like these. A = B X C…
 
                        A
 
                B            C
 
If we have the answers to A and C, we can divide C into A to determine B
 
So for our scenario A = 24k and C = 0.6. B therefore equals 40k
 
We need, absolute minimum, £40,000 to run this business. We will need more to cover the shop owner’s need of earnings of, say £30,000. Our calculation is now
(30k + 24k) / 0.6 = 90k. That’s quite a leap. We need sales of £90,000 to pay for the cost of sales, the expenses and to provide the owner with £30,000 of net profit or money the owner can draw down as desirable earnings (often known as drawings).
 
This simple example is often made more complex when such things as tax and, perhaps, depreciation of capital is considered. What is reported to HM Revenue & Customs for tax purposes might be different from the Profit & Loss report shown to a financier for obtaining capital. Taxation doesn’t deal with depreciation in the same way and tax payments are not considered an expense. Often, it is better to keep to the bear bones and leave both tax and depreciation out of the equation when discussing a business with financiers.     
 
It is hardly surprising that the Dragons fidget in their seats when they ask about turnover and profits, typically net profits, and can’t get the response they need to determine the risk they are considering. Even more harrowing is that most entrepreneurs speak in terms of projected turnover because, although orders might be secured, they haven’t yet started to sell anything, and so there is no current turnover.

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