Updated: 23rd February 2020
In business it is widely accepted that profit is a good thing. If a company is in profit it is generally assumed that the company is performing well and the future is looking bright. However, is it as straightforward as this?
Unfortunately, as with many things in business, when it comes to profit, things are not so black and white. Profit comes in many forms rather than being a one size fits all term. Simply put, profit represents the difference between the income a company has achieved during a specific period of time and the expenses incurred over the same period to generate this money. However, the way profit can be measured is varied with some of these methods more reliable than others.
Due to this it can be difficult for an investor to determine how a company is actually performing. With varying profit calculations, the same figures are often interpreted differently depending on who is presenting the company’s performance. For example, how the company may want to position itself may differ to how the media may wish to paint its fortunes. Additionally, different analysts are interested in different aspects of a company’s performance and therefore will use the profit measure which best highlights this interest.
So what are the main profit calculations used by financial professionals, investors, and businesses, and what are the advantages and potential drawbacks when using these various measures to determine business performance? More importantly, what measurement is the most reliable indicator for determining a company’s current performance as well as its on-going health?
Gross profit – Gross profit considers a company’s revenue in relation to the costs involved in making the product. However, gross profit only looks at the variable costs required to produce the product such as the raw materials and labour, also sometimes known as Cost of Goods Sold (COGS). Crucially fixed costs are omitted; these include machinery, equipment, wages, and rent. As these costs are central to the company’s operations, removing these essential costs from the calculation, means many do not believe gross profit to be a particularly valuable way of analysing a company’s core profitability.
However, for those operating in certain sectors, particularly retail, analysing a company’s gross profit can be extremely enlightening. It allows for individual product lines to be compared in order to determine which are generating a positive income and those which are draining resources.
Gross profit margin is also a useful figure to monitor when a company is looking at increasing profitability as a whole. Increasing a company’s profit margin can be done by increasing prices, lowering production costs, or a combination of the two. Gross profit is the best way of determining how successful these endeavours have been without the figures being clouded by other costs not directly related to the production and sale of the company’s key products and services.
Operating profit – Includes variable costs, as well as the wider operating (or fixed) costs, involved in creating the product or delivering the service to the end user. Often referred to as EBIT (Earnings Before Interest and Taxes), operating profit takes into account the overheads involved in producing a product, however, it does not factor in other essential outlays the company is liable to make such as deductions for taxes.