Profitability

The concept of profitability

The concept of profitability

• Profitability is the ability of a business to generate profit compared to the revenue it earns, the assets it uses, or the capital invested

  • It is a measure of how effectively a business converts sales revenue into profit

  • It is a measure of how well capital resources invested in the business generates profit

• Profitability is expressed in percentage form, which allows comparison of performance over time and with other businesses

• Several stakeholders are interested in profitability

  • Investors look carefully at profitability when deciding which business to invest in. The higher the level of profitability, the higher their rewards are likely to be

  • Directors and managers consider profitability when assessing business success and determining future objectives and strategy

  • Employees may consider profitability as justification for requesting higher wages or better working conditions 

Gross profit margin

Gross profit margin

• The gross profit margin shows the proportion of revenue that is turned into gross profit

  • It is calculated using the following formula and is expressed as a percentage

 $\mathrm{Gross} \mathrm{profit} \mathrm{margin} = \frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Sales} \mathrm{revenue}}\times 100$

• In general, the higher the gross profit margin, the better

  • It demonstrates that a business is effectively adding value

Ways to improve the gross profit margin

Increase sales revenue

• Raise prices

  • If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater

• Sell premium products

  • If customers are willing to spend money on these goods, the business could earn more profit per item sold

• Price tactics 

  • Use price tactics to encourage higher quantity or more frequent purchases

  • E.g. 'Buy one get one half price' doubles the number of items a customer purchases, increasing revenue

• Increase marketing activities

  • Engage in more marketing activities to increase sales volume

Reduce direct costs

• Direct costs are costs that can be completely attributed to the production of a specific good or services

  • Reduce variable costs 

    • Source cheaper materials, negotiate with suppliers or purchase in bulk

    • Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products

    • Buying stock in greater quantities may require more storage space, which could reduce the impact of the cost savings

  • Reduce wastage of raw materials and components

Profit margin

Profit margin

• The profit margin shows the proportion of revenue that is turned into profit before interest and tax

  • It is calculated using the formula below and the outcome is expressed as a percentage

$\text{Profit margin = }\frac{\mathrm{Profit}}{\mathrm{Sales} \mathrm{revenue}}\times 100$

• In general, the higher the profit margin, the better

• It demonstrates that a business is effectively managing expenses

Ways to improve the profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)

  • Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies

    • Reducing staffing levels may affect staff morale and negatively affect productivity

    • Relocation costs can outweigh some of the benefits of moving to a cheaper location

    • Replacing inefficient or outdated equipment may require staff training

Return on capital employed (ROCE)

Return on capital employed (ROCE)

• Return on capital employed (RoCE) measures how effectively a business uses the capital invested in the business to generate profit

  • It is calculated using the formula below and is expressed as a percentage

$\mathrm{Return} \mathrm{on} \mathrm{capital} \mathrm{employed} = \frac{\mathrm{Profit}}{\mathrm{Capital} \mathrm{employed}} \times 100$

• RoCE can be compared over time and with direct competitors

  • It can also be compared with other potential capital investments, such as savings rates

  • It is less useful to compare with businesses in contrasting industries

Interpreting the RoCE

• With RoCE, the higher the rate the better

  • This indicates that the business is profitable and using capital efficiently

    • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved

    • A ROCE of at least 20 percent is usually a good sign that the company is in a good financial position

Ways to improve RoCE

• To increase the RoCE, a business can

  • Increase the level of profit generated without introducing new capital into the business

  • Maintain the level of profit generated whilst reducing the amount of capital in the business