What is the profit equation and how is this used?

Revolut Contributor

· 07/28/2020  · 07/28/2020

Profit is defined as the amount by which the revenue of a business exceeds its costs over a given period. The implication of this point is that the basic profit equation is to deduct the appropriate costs from the total revenue that the business achieved over the same period.

Profit = Revenue – Costs

How do you calculate profit?

There are several flavours of profit, each of which is calculated by subtracting specific categories of costs from the total revenue of a business in order to assess different aspects of its performance. Before we dive into the three most common profit equations, let’s also clarify what revenue means.

In simple terms, revenue is the total value of the goods or services that the business sold during a period. We cover this idea in more detail here. People often refer to revenue as total sales or turnover and while there are some nuances, these three terms are all understood to mean the same thing. Revenue is always the top line shown on the income statement of a business.

If you deduct every type of cost from total revenue, you will calculate the net profit equation as shown below. This is often called bottom-line profit as it’s the most fundamental profit metric and also because it’s the final figure shown on an income statement.

Net profit = Revenue – Total Costs

While net profit is a keenly observed figure, it excludes so many categories of cost that some experts think it’s more insightful to use it alongside other profit metrics. If you think of the income statement as a map, with revenue at the top and net profit at the bottom, these other alternative profit metrics are destinations en route. The two best-known stop-off points are the gross profit and the operating profit.

To move from revenue down to net profit, you merely exclude cost categories shown in column one. Once you understand this, it becomes obvious how to write the profit equation for each of the metrics.

 Column One Profit metric Revenue – Direct costs (i.e. variable costs directly related to sales such as the raw materials to manufacture goods) = Gross profit Revenue – Operating expenses (e.g. rent, salaries, depreciation of fixed assets) = Operating profit Revenue – Interest & Tax (i.e. costs of finance and any taxes the business owe) = Net Profit

The easiest of the big three metrics is the gross profit equation. It’s a handy snapshot of how profitable a business is compared to its variable costs and is popular with retailers and manufacturers.

Gross profit = Revenue – Direct costs

The operating profit equation is slightly trickier. Still, it is said to provide the best overview of the financial performance of a business without the distraction of costs not controlled by managers.

Operating profit = Revenue – Direct costs – Operating costs

As mentioned, the net profit (or net income) is the most universally understood profit metric, albeit some experts believe that it is a blunt instrument in terms of the insights it delivers about a business.

Net profit = Revenue – Direct costs – Operating Costs – Interest – Tax

What is a profit margin equation?

Each profit equation shown above provides a result with an absolute monetary value. It’s easy to convert the basic metric into a ratio to reveal how much profit the business generated per pound of revenue. To do so, you divide the specific profit figure by the revenue and multiply by one hundred to create a profit margin equation. For instance, the formula to calculate the net profit margin is below but we cover margin ratios and several other types of profit equations here.

Net profit margin = (Net profit/Revenue) x100

What are the limitations of profit equations?

Profit equations provide invaluable insights into a business. However, they do have specific limits. For one thing, if the profit equation covers too broad a period – such as a whole year – it can mask any seasonal fluctuations or spikes. Another issue is that profit is not the same as cash flow. A business can be extremely profitable by any metric, yet still go bust if it doesn’t monitor this point, and runs out of liquidity. As the old saying goes: turnover is vanity, profit is sanity, but cash flow is reality.