20 January 2017
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Financial Advisory
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WHAT PROFIT AND LOSS MEANS AND ITS CALCULATIONS

The major driving force behind all economic organizations is profit. Business organizations constantly seek for ways to maximize their profit while minimizing their loss. Profit gives owners of a firm the assurance that their firm is effectively managed. Organizations constantly need fund to either invest, acquire more training or to do some other things that requires fund; one of the ways of acquiring the fund is through the profit it generates from its business activities. Profit is a great motivating force to owners of business, and so when economic organizations do not make the profit they intend to make, sooner or later, they are bound to fold up. For any business organization to be regarded as a success it must be able to effectively keep track of its profit and loss.

Any organization that does not keep track of its profit is bound to fail at some point.  Profit acts as a boundary to organizations. By this I mean, with an idea of the profit an organization earns, it can then ensure that its expenses does not exceed the amount it earns as profit. It enables those who run the organization to determine the proportion of its profit that would go to the shareholders. Profit is a great indicator of so many things. To the share holders it indicates that the business is properly managed by those it put in place to manage it. To the investor, it is an indicator that the financial resource of the organization is managed effectively thereby yielding maximum returns to the finance provided by the investors. To the government, it is an indicator that the firm is making money and so therefore must pay its tax.

The economist sees profit from a different point of view from the Accountant. While the Accountant sees profit as the financial gain that accrues to a business when the amount of revenue exceeds the expense, cost and tax incurred in the course of running such business, the economist sees it as the difference between its revenue and its implicit and explicit cost. The explicit cost includes all the monetary cost and expense incurred in the running of such business while the implicit cost includes the opportunity cost forgone during the course of running such business.

On the other end of the continuum is loss. People having put in a whole lot of human, material, financial resources and other resources in a business usually anticipate profit, but sometimes, the reverse could be the case. In as much as no organization would willingly want to make loss, it does happen. Almost all business organization that exists today would at one point or the other make loss. Making a loss does not by any way Imply that such business is a failure. 

Loss depicts the fact that organizations have not used their resources effectively. Every organization constantly seeks for ways to minimize its loss because a business that constantly makes loss would either now or later become liquidated.

If a firm’s revenue typically exceeds its cost, it means that such firm is making profit and so other profit maximizing firms may want to shift their resource into such industry.

In calculating the profit of a business, one pertinent point must be borne in mind and it is the importance of a good record system. Most often than not organizations especially those that are probably just starting do not keep accurate record, and this has often led to wrong financial decisions. If inaccurate records are kept, then inaccurate profit or loss figure will be arrived at. Wrong profit figures have great implications on organizations and these implications are negative and so proper records must be kept.

 

TYPES OF PROFIT

There are different kinds of profit:

 GROSS PROFIT: This is arrived at by deducting the cost of the goods and services it renders from the revenue it derives from the sale of such goods or services. This cost does not in any way include expenses such as wages, interest, taxes, rent, rates etc. Gross profit is a very vital indicator for the profitability of a firm. It tells us the profit we have derived from providing goods before deduction is made for overhead. It depicts the financial success of a product. If the gross profit that a company derived this year is higher than that it derived from last year after taking cognizance of inflation, it therefore means that such organization recorded more success on the sale of its products this year than it did last year. One of the very effective ways to make such comparison is through the gross profit margin. With the gross profit margin, profit made by a particular organization could be compared with profit made by the same organization for previous years or it could also be compared with profit made by other organization in the same industry.

 

Gross profit= Total revenue – cost of goods or services

 

 Net profit:  This is the profit arrived at after all expenses incurred during the course of running such business is deducted from the gross profit. The net profit shows the general performance of business overtime. The net profit is not a way of measuring the cash an organization earn; rather it enables you to know how much of the profit made can be available to meet some need like dividend, retained profit etc. potential investors often use the net profit of a firm to assess the risk of investing.  The net profit of an organization is also a critical factor that financial organizations who give loan consider. The expense here does not include tax and interest.

 

Net profit= Gross profit – expenses (excluding tax and interest.)

 

OPERATING PROFIT: This is a type of profit that is derived by further subtracting all the interest and income taxes associated with the business from the net profit. Operating profit is a measure of managerial competency. In some way, it is an indirect means of measuring the efficiency of a business.

After deducting the interest and the income taxes from the net profit, it is left to the managers of the business to decide what to do with the available profit. They could choose to distribute some portion to its owners and retain the remaining profit or it could choose to retain all.

 Operating profit=net profit – tax and interest.

 

Author

Loveth Ogor is a final year Accounting Students at the University of Benin.

 

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