Understanding how businesses can improve profit and profitability is crucial for ensuring long-term success and financial sustainability.
What Is Profit?
Profit is the amount of money a business retains after deducting all costs associated with operating the business. It is one of the most important indicators of business performance and financial health. Profit allows for reinvestment, debt repayment, and shareholder returns. There are three main types of profit that are often examined in financial analysis:
Gross Profit
This is the profit a business earns after subtracting the cost of goods sold (COGS) from revenue. COGS includes direct costs like raw materials and labour involved in production.
Gross Profit = Revenue - Cost of Goods Sold (COGS)
A higher gross profit suggests that a company can sell products at a good markup over the cost of production. It does not, however, account for other expenses such as rent or wages.
Operating Profit
This is the gross profit minus the operating expenses. Operating expenses include rent, wages, utilities, and administrative costs but exclude interest and taxes.
Operating Profit = Gross Profit - Operating Expenses
It gives a clearer picture of how efficiently a business runs its day-to-day operations and is also known as EBIT (Earnings Before Interest and Taxes).
Net Profit
This is the final profit after all costs, including operating expenses, interest payments, and taxes, have been deducted from the revenue.
Net Profit = Operating Profit - Interest - Taxes
Net profit is often referred to as the ‘bottom line’ and reflects the actual profit available to shareholders or for reinvestment into the business.
What Is Profitability?
While profit measures absolute earnings, profitability evaluates how well a business turns revenue into profit. It indicates financial efficiency and is usually expressed as a percentage.
Gross Profit Margin
Shows the proportion of revenue that exceeds COGS. It helps determine how efficiently a business produces its goods or services.
Gross Profit Margin = (Gross Profit ÷ Revenue) × 100
Operating Profit Margin
Reflects the percentage of revenue left after operating expenses are deducted. It shows how efficiently a business runs its core operations.
Operating Profit Margin = (Operating Profit ÷ Revenue) × 100
Net Profit Margin
Measures the percentage of revenue that remains as net profit after all costs are deducted.
Net Profit Margin = (Net Profit ÷ Revenue) × 100
A higher margin at any level suggests stronger profitability and more room to withstand cost pressures.
Methods of Increasing Revenue
Increasing revenue is one of the most direct ways to boost profit, provided that cost increases do not outpace the gains in income. Here are some of the main approaches:
Increasing Prices (When Demand Is Inelastic)
Raising prices can lead to higher revenue and profit if customers are not highly sensitive to price changes, i.e. if demand is inelastic.
Inelastic demand occurs when a change in price results in a smaller percentage change in quantity demanded.
Examples: essential medication, petrol, electricity.
Advantages:
Quick way to increase revenue without changing the product or operations.
No need for higher sales volume to improve profit.
Disadvantages:
May backfire if demand is more elastic than expected.
Can damage customer relationships if perceived as unjustified.
Competitors may undercut pricing, leading to a loss in market share.
Boosting Marketing Efforts
Strategic marketing can expand market reach and encourage repeat purchases. Investing in promotional activities may generate higher sales volumes and customer loyalty.
Examples of marketing activities:
Social media advertising targeting specific demographics.
Seasonal promotions or discounts.
Email campaigns or loyalty programmes.
Benefits:
Increases brand awareness and drives traffic to products or services.
Can differentiate the business in a crowded marketplace.
Risks:
Costly campaigns may not yield proportional returns.
May need to be sustained for long-term impact.
Product Development and Adding Value
Developing new products or improving existing ones adds value and can justify higher prices.
Methods of adding value:
Improve product features or design.
Use higher-quality materials.
Offer better customer service or warranties.
Benefits:
Enhances customer satisfaction and loyalty.
Opens up premium pricing opportunities.
Risks:
Research and development (R&D) can be expensive.
There is a risk that the new product won’t be successful in the market.
Methods of Reducing Costs
Reducing costs is another key strategy to increase profit, especially if revenue growth is limited. It must be managed carefully to avoid harming quality or customer experience.
Sourcing Cheaper Suppliers
Finding alternative suppliers who offer better rates can reduce production or purchase costs.
Benefits:
Direct reduction in COGS.
Improves gross profit margins.
Risks:
Lower price may come with lower quality.
Potential delays or unreliable supply chain.
Businesses should consider long-term reliability, not just price.
Increasing Productivity
Raising output levels per worker or per unit of input improves efficiency and reduces cost per unit.
Ways to improve productivity:
Implement training programmes to enhance employee skills.
Invest in modern machinery or technology.
Introduce performance-based incentives.
Advantages:
Enhances workforce morale and output.
Improves operating efficiency.
Drawbacks:
Initial investment in training or equipment can be high.
Risk of overworking employees if not managed properly.
Cutting Waste and Improving Efficiency
Reducing material waste, idle time, and inefficient processes can lead to major cost savings.
Tactics include:
Lean production methods (e.g. Just-In-Time inventory).
Regular maintenance of equipment to avoid downtime.
Streamlining logistics and supply chains.
Benefits:
Lower costs without impacting product quality.
Can lead to a more sustainable operation.
Risks:
Requires careful monitoring and change management.
Can involve upfront investments.
Improving Profitability through Product Mix and Customer Targeting
Profitability can also be improved by strategic decisions that shift the business towards more profitable areas or customers.
Changing the Product Mix
This involves focusing on selling products with higher profit margins and possibly discontinuing low-margin lines.
Example:
A bakery reduces sales of low-margin bread and focuses on premium cakes and pastries.
Advantages:
Increases average profit per sale.
Allows better use of resources.
Risks:
Removing popular but low-margin items could alienate existing customers.
Higher-priced items may require stronger branding and marketing.
Customer Targeting
Targeting customer segments that are more likely to buy high-margin products or spend more per transaction can improve overall profitability.
Methods:
Use customer data to identify high-value segments.
Tailor products or marketing messages to meet their needs.
Develop loyalty programmes or premium services.
Advantages:
Builds long-term customer relationships.
Increases customer lifetime value.
Risks:
High-value customers often expect better service.
May lead to neglect of existing broader customer base.
Worked Margin Examples
Example 1: Calculating Gross Profit Margin
A company sells a product for £80 and the cost to produce the product is £40.
Gross Profit = £80 - £40 = £40
Gross Profit Margin = (£40 ÷ £80) × 100 = 50%
This means that 50% of the revenue remains after covering the direct cost of the product.
Example 2: Calculating Net Profit Margin
Suppose a business has:
Revenue: £500,000
COGS: £250,000
Operating Expenses: £150,000
Interest and Taxes: £30,000
Step-by-step:
Gross Profit = £500,000 - £250,000 = £250,000
Operating Profit = £250,000 - £150,000 = £100,000
Net Profit = £100,000 - £30,000 = £70,000
Net Profit Margin = (£70,000 ÷ £500,000) × 100 = 14%
This means the business retains 14p for every £1 of revenue after all expenses.
Case Studies for Application
Case Study 1: Café Boosts Profit via Product Mix
A small café was making low margins on mass-market soft drinks and sandwiches. To improve profit:
Introduced high-margin items like artisan coffee and premium pastries.
Removed low-margin bottled drinks.
Offered a loyalty card to encourage repeat purchases.
Results:
Gross profit margin rose from 58% to 70%.
Weekly revenue remained steady, but net profit increased by 18%.
Customers perceived the café as more premium.
Lesson: Rebalancing the product mix can significantly improve profitability without needing more customers.
Case Study 2: Online Retailer Cuts Costs to Boost Profit
An e-commerce business faced tight margins due to rising operational costs. The business:
Negotiated cheaper delivery contracts with logistics providers.
Improved warehouse layout to speed up order fulfilment.
Automated customer service using AI chatbots.
Outcomes:
Operating costs fell by 12% within four months.
Net profit margin improved from 10% to 16%.
Customer satisfaction remained stable due to faster deliveries.
Lesson: Cost reduction, when well-managed, can improve profit while maintaining customer experience.
Case Study 3: Pharma Company Increases Prices Due to Inelastic Demand
A pharmaceutical firm produced a unique medication with no close substitutes. Market research showed that demand was inelastic.
Increased prices by 8% without altering product features.
Monitored customer feedback and found minimal complaints.
Used extra profit to fund new drug development.
Results:
Revenue increased by £2 million annually.
Net profit margin increased from 22% to 29%.
Competitors could not match due to regulatory restrictions.
Lesson: Understanding price elasticity can lead to profitable pricing strategies.
Improving profit and profitability requires a multi-faceted approach, balancing pricing, cost control, product strategy, and customer focus. The key lies in making informed decisions based on data, financial analysis, and strategic goals.
FAQ
Improving profit means increasing the absolute amount of money a business makes after costs—this could be through higher sales or lower expenses. Improving profitability refers to how efficiently a business turns revenue into profit, typically measured by margins. A business could earn more profit but still have lower profitability if its revenue has grown faster than its margins. Understanding the difference matters because high profit doesn’t always mean financial efficiency, and low profitability can signal underlying cost issues even if profit appears strong.
While raising prices in an inelastic market can boost revenue, businesses may avoid doing so to maintain customer goodwill, brand loyalty, or competitive positioning. Over time, repeated price hikes can erode trust and push customers to explore alternatives. In regulated sectors, such as energy or pharmaceuticals, price increases may also draw negative attention or legal limitations. Moreover, price changes can complicate forecasting and demand planning, making some firms prefer revenue growth through volume or added value instead.
Improving productivity means producing the same output with fewer inputs—such as labour, time, or materials—thereby reducing unit costs. For example, automating part of a manufacturing process or optimising a supply chain can lower waste and improve resource usage. Even if output remains the same, the cost savings directly enhance profit margins. This increases profitability because the business is earning more per pound of revenue by controlling expenses and streamlining operations, which strengthens long-term financial performance.
Customer segmentation enables a business to identify which customer groups are most profitable and tailor offerings accordingly. By focusing marketing efforts and product development on high-margin segments—such as luxury buyers or loyal repeat customers—firms can increase average revenue per customer. It also allows more efficient use of resources by avoiding low-value segments. Segmentation helps businesses deliver better-targeted value, reduce unnecessary marketing spend, and enhance pricing strategies, all of which contribute to improved profitability over time.
Value-added strategies focus on enhancing the perceived worth of a product or service—such as through better design, customer service, or exclusive features—allowing firms to charge premium prices and improve profit margins. In contrast, cost-cutting targets reducing expenses to boost profit without necessarily altering the customer offering. While cost-cutting can deliver short-term gains, value-added strategies are often more sustainable as they strengthen brand loyalty and differentiate the business. Combining both approaches strategically can maximise long-term profitability.
Practice Questions
Analyse how changing a product mix could help improve a business’s profitability. (9 marks)
Changing a product mix allows a business to focus on higher-margin products, increasing the average profit per unit sold. For example, replacing low-profit items with premium offerings can boost gross profit margins without needing higher sales volumes. This strategy also helps businesses differentiate themselves and attract more profitable customer segments. However, it must be carefully managed, as removing popular low-margin items could reduce footfall. Success depends on understanding customer demand and aligning products with market expectations. Overall, an effective product mix change improves financial efficiency and helps maintain profitability, particularly in competitive or saturated markets.
Evaluate the usefulness of increasing prices to improve profitability for a business selling inelastic products. (16 marks)
Increasing prices when demand is inelastic can be highly effective for boosting profitability, as sales volumes typically remain stable. This means revenue rises without a proportional rise in costs, leading to higher gross and net profit margins. For example, a utility company or a pharmaceutical firm may benefit due to the essential nature of its products. However, overreliance on price increases can attract regulatory scrutiny or damage customer trust. In the long term, innovation and added value may be more sustainable strategies. Overall, increasing prices is useful but must be considered alongside brand image and customer perception.
