Understanding how businesses measure and evaluate profit is vital for analysing performance, guiding decision-making, attracting investors, and ensuring long-term sustainability.
Key Financial Terms
Before learning how profit is measured, students must understand the key financial terms used in calculating profit. These terms form the foundation for analysing business financial performance.
Revenue (also known as Sales or Turnover)
Revenue is the total amount of money a business earns through the sale of goods or services. It does not consider any of the costs associated with producing those goods or delivering those services. Revenue is often used as a top-level indicator of business activity and market demand.
Formula:
Revenue = Price × Quantity Sold
For example, if a business sells 300 units of a product at £10 each, its total revenue is:
Revenue = £10 × 300 = £3,000
Revenue can be split into:
Sales revenue from core operations (e.g. selling physical goods or services)
Other operating revenue (e.g. rental income, commissions)
Fixed Costs
Fixed costs are business expenses that do not change with the level of output or sales. These remain constant whether the business sells one item or one thousand items. Fixed costs are typically associated with the basic operation of the business and must be paid regardless of the volume of business activity.
Examples of fixed costs include:
Rent or mortgage payments
Salaries of full-time staff
Insurance premiums
Depreciation of assets
Business rates
Fixed costs are essential to calculate because they represent the baseline expenses a business must cover before it can start making a profit.
Variable Costs
Variable costs are expenses that change depending on the level of output or sales. The more the business produces or sells, the higher the variable costs. These costs are directly tied to the product or service being delivered.
Examples of variable costs include:
Raw materials and components
Hourly wages or direct labour
Utility costs directly linked to production (e.g. electricity for manufacturing)
Packaging
Delivery and shipping costs
Understanding variable costs helps in pricing decisions and managing margins. Businesses often seek to reduce variable costs to increase profitability.
Total Costs
Total costs are the complete sum of all fixed and variable costs. This figure is critical because it represents the total amount the business needs to cover to break even and eventually generate profit.
Formula:
Total Costs = Fixed Costs + Variable Costs
For instance, if a company has fixed costs of £2,000 per month and variable costs of £5 per unit for 400 units, then:
Variable Costs = £5 × 400 = £2,000
Total Costs = £2,000 (fixed) + £2,000 (variable) = £4,000
Knowing total costs allows the business to assess the minimum revenue needed to be profitable.
Formula Focus
Accurate use of formulas is essential for evaluating profitability. These formulas help assess performance, pricing strategy, and the potential for expansion.
Revenue Formula
Revenue = Price × Quantity Sold
This helps calculate the total income a business earns from selling its products or services.
For example:
If a café sells 150 cups of coffee daily at £3 each:
Revenue = £3 × 150 = £450 per day
Total Costs Formula
Total Costs = Fixed Costs + Variable Costs
This formula ensures businesses account for all expenses.
For example:
If monthly fixed costs are £1,500 and variable costs per unit are £4 for 500 units:
Variable Costs = £4 × 500 = £2,000
Total Costs = £1,500 + £2,000 = £3,500
Profit Formula
Profit = Revenue – Total Costs
This key formula shows whether the business is operating at a gain or loss.
Continuing the example:
Revenue = £4 × 500 = £2,000
Total Costs = £3,500
Profit = £2,000 – £3,500 = –£1,500 (a loss)
If profit is positive, the business earns more than it spends. If negative, it is running at a loss.
Worked Examples
To build student confidence, here are some step-by-step examples applying the formulas:
Example 1: Small Business Profit Calculation
A florist sells 600 bouquets at £25 each in a month. The fixed costs for running the shop are £3,000 per month. Each bouquet costs £10 to make (including flowers, wrapping, and labour).
Step 1: Calculate Revenue
Revenue = £25 × 600 = £15,000
Step 2: Calculate Variable Costs
Variable Costs = £10 × 600 = £6,000
Step 3: Calculate Total Costs
Total Costs = Fixed Costs + Variable Costs = £3,000 + £6,000 = £9,000
Step 4: Calculate Profit
Profit = Revenue – Total Costs = £15,000 – £9,000 = £6,000
This means the florist made a healthy monthly profit of £6,000.
Example 2: Identifying a Loss in a New Business
A start-up gym has fixed monthly costs of £7,000. It charges members £50 per month. In its first month, it signs up 100 members. The variable cost per member (e.g. maintenance, water, staff per member) is £10.
Step 1: Revenue = £50 × 100 = £5,000
Step 2: Variable Costs = £10 × 100 = £1,000
Step 3: Total Costs = £7,000 + £1,000 = £8,000
Step 4: Profit = £5,000 – £8,000 = –£3,000 (a loss)
The gym made a loss, which is common in the early months of trading when fixed costs are high, and the customer base is still growing.
Why Profit Matters
Profit is a key measure of success for most businesses. It has several essential purposes beyond simply making money for owners.
1. Return for Investors
Investors (e.g. shareholders, venture capitalists) expect returns on their investment.
Profit allows companies to pay dividends, attracting and retaining shareholders.
High profits also indicate strong business performance, increasing share value.
2. Reinvestment in the Business
Profit provides capital to:
Upgrade technology
Open new locations
Research new products
Train employees
Reinvestment fuels long-term growth and competitiveness.
Example: A technology company might reinvest profits into product innovation to stay ahead of rivals.
3. Creditworthiness and Business Survival
Profitable companies are more likely to secure loans from banks.
Lenders assess profit levels when evaluating risk.
Profit also acts as a buffer in difficult times (e.g. during economic downturns).
Without profit, businesses may struggle to pay bills, wages, or suppliers, putting their survival at risk.
4. Motivation and Rewards
Businesses often use profits to:
Provide staff bonuses or incentives
Offer promotions or pay rises
Introduce profit-sharing schemes
This boosts employee morale and encourages productivity, especially in smaller firms where performance is closely tied to outcomes.
Example: A retail company might offer store managers a share of profits to improve store performance.
Profit is therefore not just a financial goal but also a tool for growth, security, and motivation.
Limitations of Profit as a Sole Objective
While profit is vital, relying on it alone can lead to short-sighted or unethical decision-making. Many modern businesses balance profit with other priorities, such as ethics and sustainability.
1. Social and Ethical Responsibilities
Focusing only on profit might lead businesses to:
Cut corners on employee safety
Ignore environmental regulations
Underpay workers
Exploit customers with unfair pricing
Example: A clothing brand seeking high profits might use cheap overseas labour, attracting criticism and harming its brand image.
2. Corporate Social Responsibility (CSR)
CSR is when businesses voluntarily commit to ethical practices, such as:
Reducing carbon emissions
Supporting local communities
Using ethical supply chains
These actions may reduce short-term profits but enhance brand reputation and attract ethical consumers.
Example: A coffee company paying above-market prices for beans to support farmers may gain loyal customers despite higher costs.
3. Long-term Sustainability Risks
Prioritising immediate profits can compromise:
Product quality
Customer satisfaction
Employee wellbeing
Short-termism may improve quarterly figures but damage the business in the long term.
Example: Cutting costs on raw materials may lead to defective products and customer complaints.
4. Alternative Business Objectives
Not all businesses aim for maximum profit. Some have non-profit or social goals, such as:
Charities aiming to fund services
Social enterprises balancing income with positive impact
Cooperatives seeking shared benefits for members
These businesses still monitor profit to stay viable, but it is not the main purpose.
Modern business models often focus on the Triple Bottom Line:
People: Fair treatment of employees and communities
Planet: Environmental sustainability
Profit: Financial viability
This reflects a growing understanding that businesses operate within wider society and must behave responsibly.
FAQ
Gross profit is the amount left after deducting only the variable costs (also known as the cost of sales) from the revenue. It shows how efficiently a business produces its goods or services. Net profit, also known as profit for the year, is the amount remaining after all expenses are deducted, including fixed costs, interest, and tax. Net profit gives a clearer picture of the business’s overall financial health, while gross profit focuses more on operational efficiency.
A business can increase profit without raising prices by reducing costs, improving operational efficiency, or increasing sales volume. Reducing variable costs—such as negotiating better deals with suppliers—can increase the profit margin per unit. Minimising fixed costs like rent or utilities also helps. Investing in technology or training can improve productivity and reduce waste. Additionally, increasing marketing effectiveness to drive more sales at the same price point improves revenue without affecting customer pricing perception.
Profit and cash flow are related but not identical. Profit is the surplus after all costs are deducted from revenue over a specific accounting period. It is an accounting measure and includes non-cash items like depreciation. Cash flow, however, refers to the actual movement of money into and out of the business. A company can be profitable on paper but still struggle to pay bills if customers delay payments or if money is tied up in unsold stock or equipment.
Profit margin is the percentage of revenue that remains as profit after costs are deducted. It helps businesses assess how efficiently they are converting sales into profit. Common types include gross profit margin, operating profit margin, and net profit margin. For example, a 25% net profit margin means that for every £1 earned, 25p is kept as profit. Businesses use profit margins to evaluate performance, compare with competitors, and make strategic pricing or cost decisions to improve profitability.
A business can survive temporarily without making a profit, especially during its early stages or when reinvesting for growth. However, long-term survival without profit is unlikely. During periods of loss, businesses rely on external funding (loans, investments) or retained cash reserves to cover expenses. Continuous losses weaken a business’s creditworthiness, reduce investor confidence, and limit future opportunities. For survival, the business must eventually become profitable to sustain operations, repay debts, and fund future development independently.
Practice Questions
Analyse why profit is important for a small start-up business. (6 marks)
Profit is crucial for a small start-up because it determines the business's ability to survive and grow. In the early stages, start-ups face high fixed costs and often limited revenue, so achieving profitability is essential for covering costs and avoiding insolvency. Profit allows reinvestment into operations, such as hiring staff, marketing, or product development. It also builds confidence among investors or lenders, improving the firm’s access to external finance. Furthermore, profit can be used to motivate the founder or team through financial rewards, which is especially important when initial workloads are high and uncertain returns are expected.
Calculate the profit made by a business that sold 2,000 units at £15 each. The fixed costs were £10,000, and variable costs were £5 per unit. (4 marks)
Revenue = 2,000 units × £15 = £30,000
Variable Costs = 2,000 × £5 = £10,000
Total Costs = £10,000 (fixed) + £10,000 (variable) = £20,000
Profit = Revenue – Total Costs = £30,000 – £20,000 = £10,000
The business made a profit of £10,000. This shows it has covered all costs and generated a surplus, which could be used for reinvestment or retained earnings. The use of formulae shows a clear understanding of how profit is calculated in a real business scenario.
