Understanding Business Accounting For Dummies, 2nd Edition (33 page)

Chapter 5
:
Profit Mechanics

In This Chapter

Getting the lowdown on profit

Analysing the different steps in making profit

Locating where the profit ends up

Reporting a profit or loss

Reporting unusual gains and losses in the profit and loss account

I
n this chapter we lift up the bonnet and investigate how the profit engine runs. At first glance, making profit may seem fairly simple - sell stuff and control expenses. Bring in more pounds from sales revenue than the pounds paid out for expenses. The excess of revenue over expenses is profit. What's the big deal?

Well, making a profit and determining its amount isn't nearly as simple as you may think. This chapter starts with a simple case in which the increase in cash is equal to profit - the business collects cash for all of its sales during the period and pays out cash for all of its expenses, and profit equals the cash left over. But alas, the business world is not so simple. So the chapter continues one step at a time to build a realistic profit model. Walking through this example lets you answer one very important question: At the end of the day, where exactly is your profit that you worked so hard to earn?

Swooping Profit into One Basic Equation

For a business that sells products, its profit equation is simply sales revenue - expenses = profit, which almost always is reported in a vertical format like this:

Basic Profit Equation

Sales Revenue £1,000,000

Less Expenses
£940,000

Equals Profit
£60,000

Profit, in short, equals what's left over from sales revenue after you deduct all expenses. (You never see the term net sales revenue instead of profit.) This business earned £60,000 on £1,000,000 total sales revenue for the period, which is 6 per cent. Expenses used up 94 per cent of sales revenue. Although it may seem rather thin, a 6 per cent profit margin on sales is typical for many businesses - although some businesses consistently make a bottom-line profit of 10-20 per cent of sales, and others are satisfied with a 1 or 2 per cent profit margin on sales revenue. Normal profit ratios vary widely from industry to industry.

Businesses that sell services instead of products also use the term
sales revenue
for
gross income
(total income before deducting expenses) from sales of their services - but you also see variations on this term. Businesses that don't sell anything as such - financial institutions that earn investment income, for example - use other terms for their gross income.

Notice the following points about the basic profit equation:

Even though you're deducting expenses from sales revenue, you generally don't use a minus sign or parentheses to indicate that the expense amount is a negative number (although some people do).

Using a double underline under the profit number is common practice but not universal. Some people use bold type. You generally don't see anything as garish as a fat arrow pointing to the profit number or a big smiley encircling the profit number - but again, tastes vary.

Profit isn't always called
profit.
It's often called
net income
or the
bottom line
or - particularly on financial reports intended for people outside the business -
net
earnings.
(Can't accountants agree on
anything
?) Throughout this book we use the terms
net income
and
profit
pretty much interchangeably.