0264 · 5.3.1What is profit and why it is important

Calculating profit and loss

0:00A busy shop can serve customers all day and still struggle financially. Every sale brings income, but supplying products and running the premises also creates costs. The amount left after those costs tells us something important about the business. By the end of this video, you will understand how to calculate profit and why owners, managers and finance providers care about it. Revenue is the income a business receives from selling goods or services.

0:25Total costs are all the costs of running a business over a particular period. These include materials, wages, rent and electricity. To understand the financial result, we compare revenue with total costs for the same period. Profit is total revenue minus total costs. It is the surplus that remains after the business covers all its costs for the period. The formula works because revenue must first cover the resources used to earn it.

0:50Any remaining amount represents the financial reward from the business activity. A loss is when total costs are greater than total revenue. In that situation, the income earned falls short of the costs incurred. Owners need to understand the size and cause of that shortfall. Repeated losses can threaten the business’s ability to continue operating. Bramble Works makes wooden tables. During one year, its revenue is eighty thousand dollars and its total costs are sixty-five thousand dollars.

1:17Both figures cover the same year, and the cost figure includes every cost of running the business. Profit equals total revenue minus total costs. Eighty thousand dollars minus sixty-five thousand dollars gives fifteen thousand dollars. The business therefore makes a profit of fifteen thousand dollars for that year. Of the revenue earned, sixty-five thousand dollars covers its total costs. The remaining fifteen thousand dollars is the surplus from its activities.

1:45Thistle Stays provides holiday accommodation. Its revenue for one year is forty-two thousand dollars, while total costs for that period are forty-nine thousand dollars. Forty-two thousand dollars minus forty-nine thousand dollars gives minus seven thousand dollars. Total costs are greater than total revenue, so the business makes a loss of seven thousand dollars.

Why profit matters

2:04The private sector is businesses owned and controlled by private individuals. Their owners commit resources to activities whose results are uncertain. Profit helps make that commitment worthwhile and supports the business’s future. It matters to these businesses for four main reasons. The four main reasons are reward for risk-taking, source of finance, measure of success and attracting investors. Each reason explains a different relationship between the business and the people supporting it.

2:32Owners look for a reward, while managers need resources and evidence of performance. Potential finance providers want confidence about future returns. An entrepreneur is a person who organises, operates and takes the risk for a new business venture. A shareholder owns part of a limited company. Both can commit money to a business with an uncertain outcome. Profit provides a potential reward for accepting that uncertainty. For example, the owner of Bramble Works pays for equipment before knowing how many customers will buy its tables.

3:02Weak demand could leave the business making a loss. When sales generate profit, the owner can receive a financial reward for taking that risk. Shareholders can also receive part of a limited company’s profit in return for their investment. Retained profit is the part of the surplus kept in the business after the owners receive their share. Keeping some of it back gives the business an internal source of finance.

3:24Bramble Works could use this money to help purchase another cutting machine. Greater capacity would allow it to make more tables and support expansion. There is a choice between rewarding owners now and keeping resources for future development. A business that distributes more of its profit leaves less available to finance expansion internally. Managers therefore consider what the business needs alongside owners’ expectations. The importance here is that retained profit gives the business funds from its own activities.

3:52Profit also provides a measure of success because it shows whether revenue exceeds total costs. Managers can compare the result with earlier years to judge changes in financial performance. A rising figure may reflect stronger sales or better control of costs. They should examine the reasons behind the change before deciding what to do next. Comparisons with competitors can also help managers judge performance. Businesses in the same industry provide useful reference points because they face similar activities and customer needs.

4:22Size affects the comparison, so managers should consider that context alongside the amount earned. Profit provides evidence of financial success, while customer satisfaction and other objectives add further information. Investors are people or organisations that commit money with the aim of earning a financial return. A record of profit can make a business more attractive to potential shareholders. It provides evidence that the activities can generate a surplus from which owners may receive payments.

4:49Investors also consider whether that performance can continue. Interest is the payment made for borrowing money. Lenders supply finance with the expectation of repayment and interest. A profitable business gives them greater confidence that it can meet these obligations. So shareholders are more willing to buy shares, while lenders are more willing to lend.

Exam answers and recap

5:09Revenue is not profit. Revenue measures income from selling, while profit measures the surplus after total costs. Cash is the money a business holds as notes and coins and in its bank account. Profit is not the same as cash, as you will see in the video on the importance of cash and cash flow forecasts. Fernbank Repairs provides bicycle repair services and aims to open a second workshop. An exam-style question could ask you to explain why profit is important to this business.

5:37Explain means set out purposes or reasons, say why and how, supported with relevant evidence. Connect the reason to the workshop expansion in your answer. Retained profit provides an internal source of finance for Fernbank Repairs. The business can use these funds to purchase equipment for its second workshop. So the expansion is paid for with money its existing workshop has already earned. A record of profit can also attract investors, so Fernbank Repairs could raise extra finance for the second workshop.

6:05For calculation questions, use revenue and total costs from the same period, then state the result in dollars. When the result is negative, state it as a loss in dollars. For explanation questions, connect the reason to a specific business outcome. That connection shows why profit matters in the circumstances given. Remember that profit is total revenue minus total costs. A loss is when total costs are greater than total revenue.

6:31The surplus can reward risk-taking, provide finance for expansion and offer evidence of financial success. It can also attract investors by showing that the business has generated funds from its activities.