tutor2u | Measurement & Importance of Profit

Study Notes

Measurement & Importance of Profit

Level:
AS, A Level
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 14 Apr 2017

Profit is perhaps the most important concept in business, so it is vital to understand what profit is, how it is calculated and why it is important.

What is Profit?

Profit is:

  • A return on investment
  • A reward for taking risks
  • A key source of finance
  • A measure of business success
  • A motivating factor & incentive

A good definition of profit is "the reward or return for taking risks & making investments".

For most businesses, making a profit is a key business objective. You also need to appreciate that profit is also the most important source of cash flow & finance for a business.

However, don’t forget that there can be reasons for running a business other than the “profit motive”. For example, social enterprises exist to make a return that can be reinvested to meet society aims.

How Profit is Calculated

Profit can be calculated as:

Total Sales (Revenues) less Total Costs

The profit earned by a business can be measured in both absolute and relative terms.

Profit in absolute terms would measure the £ value of profits earned in a specific period - e.g. £1 million profit made in the year.

Profit in relative terms would look at the profit earned as a proportion of revenues achieved or investment made.

  • E.g. £50,000 profit from £500,000 of sales is a profit margin of 10% (£50,000 / £500,000)
  • E.g. £50,000 profit from an investment of £1 million = a 5% return on investment

Why is Profit Important?

In most businesses profit is the reward that the owners of the business want to achieve from taking risks and making investments.

Without the possibility of earning a profit, what would the incentive be to take risks by, for example, setting up a new business, or investing capital to expand an existing business?

Profit, like the positive cash flows that it helps create, can be seen as the lifeblood of a successful and valuable business. A business that fails to achieve profit and instead suffers sustained losses will struggle to survive.

The profit incentive is strong in nearly all businesses, although as you will discover when studying corporate social responsibility, earning a profit is now often seen as just one part of the responsibilities of business. In Elkington's Triple Bottom Line model, for example, you'll discover that Profit is seen as part of a group of three key performance indicators for business activity alongside People and Planet.

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