1. Profit 3 lessons covering profit. We will look at: a)Calculation of: – gross profit – operating profit – profit for the year (net profit) b)Statement of comprehensive income (profit and loss account) c)measuring profitability: – calculation of gross profit margin, operating profit margin, and profit for the year (net profit) margin – ways to improve profitability d)Distinction between profit and cash

2. Statement of comprehensive income Income Statement All plcs (what are these?) have to publish documents showing financial performance including a statement of comprehensive income. Sometimes called a profit and loss account Each type of profit is calculated after allowing for different types of costs Gross profit is profits after allowing for the cost of producing the good, eg raw materials (essentially variable costs) Fixed overheads means rent, electricity etc, ie fixed costs Financing costs means the cost of borrowing eg interest costs on loans Look up Ted Baker’s financial accounts Items £000 Revenue 1050 minusCost of sales 500 equalsGross profit 550 minusFixed overheads 250 equalsOperating profit 300 minusNet financing costs 10 andTax 60 equals Profit for the year (net profit) 230

3. Revenues As before, price times quantity – Q3 2015 iPhone 47.5m times $660 = $31,400m!! – Toyota selling 8.7m vehicles in 2013 at $25,000 = $217,000m Revenue recognised when ownership has changed hands, not when cash is received!

4. Cost of sales – variable costs Raw material costs – Toyota – steel, tyres, any materials/components they buy – Tesco – cost of food or any product they sell Other direct costs – Workers on the production line

5. Fixed overheads These are the overheads of the business ands are incurred whatever the level of output Salaries, rent, utilities, marketing, insurance, administration costs

6. What makes a profit good? Is gross profit of £25 million good or bad What about operating profit of £40,000 Cannot tell from this, because a bigger firm should make a higher profit than a smaller one – Gross profit of £25 million for Starbucks would be disastrous, but an operating profit of £40,000 for Italian Taste is probably quite good! Should compare profits with revenues Called margins and are in %

7. Margins We can calculate margins from the income statement: – gross profit margin is (gross profit/revenues) x 100 – Operating profit margin is (operating profit/revenues) x 100. This is my favourite of the profit margins – Net profit margin is simply (net profit/revenues) x 100 £000 Revenue1050 Gross profit550 Operating profit300 Interest10 Tax60 Net profit230 Gross profit margin Operating profit margin Net profit margin

8. The value of calculating margins Once margins have been calculated, stakeholders (the management, investors etc) can analyse them and ask questions, such as: – What has happened to a particular margin over the last year or several years? – How do profit margins compare with competitors? Question: which companies will have high margins?

9. What is a good net profit margin? Depends on the industry – Industries with high sales volumes can still make good profits with low net profit margins eg food retail. In this case 5% would be excellent – Industries/firms selling luxury items often make higher profit margins. Gucci, Apple. Can easily make 20% or more – Always compare with: Previous year or years, so higher is good With competitors, so higher is good

10. Calculations FirmRevenues (£000)Net profits (£000)Net profit margin A15,000750 B800100 C3,0001,200 D5,000100 E40,000,00012,000,000

11. How to improve profits 1 Profits = revenues minus costs, so increase revenue or cut costs 1.Cut costs. How? a)Cut variable costs – buy cheaper raw materials, or switch supplier. Also manage stocks and cut waste b)Cut fixed costs – reduce staff, find cheaper location, cut promotion/advertising c)Produce more efficiently – better technology

12. How to improve profits 2 But cutting costs can be problematic. Why? Cutting variable costs can mean lower quality, which can damage the brand, leading to lower demand and so lower revenue, which means profits might not be increased Cutting fixed costs. Need to be careful that the location is suitable – near customers, convenient for key employees. Cutting staff can be dangerous – need a minimum number, and customer service may be affected Improving technology may lower costs, but may also be expensive (and so might not lower costs). Technology doesn’t always work either!

13. How to improve profits 3 Improve revenues. Consider the marketing mix (product, promotion, place, price) – Change the price Lower it if PED is high, so a cut in price will lead to a sharp increase in demand. Effective if there are many competitors Increase it if PED is low, so a price increase will not – Change the product to make it more appealing – Change promotion to make it better known (but this costs money) – Improve distribution to make the product more available

14. How to improve profit margin Similar to improving profits, but in this case it means increasing profits relative to revenues – Obvious way is to raise the price. Can then make more profit (contribution) per unit. But demand will fall, so it depends on PED. IF PED is high, an increase in price will raise profit per unit, but if the number of units falls a lot, profits could actually fall. – Cut costs. As before.

15. Difference between cash flow and profits You must not confuse them. They are not the same – Easy to think revenues = cash coming in But not all revenues mean cash coming in (at that time) There are other reasons for cash inflow – Also easy to think costs – cash going out But not all costs mean cash goes out (at that time) There are other reasons for cash going out

16. Cash vs revenues costs and profits ItemCash in or outRevenue or cost Cash SaleCash inrevenue Credit saleNo cash in or outrevenue Bank loanCash inneither Sale of an assetCash inneither Selling shares to raise moneyCash inneither Buying raw materials on creditNo cash in or outcost Sale and leasebackCash inneither