In cost accounting, profitability is an examination of the actual profitability of an enterprise’s output under a given set of circumstances. Output of an enterprise can be grouped into fixed assets, goods, services, locations, processes and/or sales. Under optimum conditions, the enterprise’s output should be able to cover all the costs it incurs in producing that output and still leave sufficient profits for the enterprise. Under normal circumstances, profitability is determined by the overall revenue performance of the enterprise.
Under normal circumstances, revenue growth, operating income and expense growth are balanced on a continual basis. Revenue increases with the increase in production and service, and decreases with the reduction of production and service. Profitability, on the other hand, is determined by changes in the total amount of net profits, less the amount of total expenses. Net profits are reported under the heading of gross profit. The difference between gross profit and net profit, however, indicates the profitability or potentiality of the business operation. The difference is called the operating profit margin.
An important concept in profitability is the difference between revenue coming in and revenue going out. If revenue is increasing, profit is increasing as well; conversely, if revenue is decreasing, profit is decreasing. A positive net profit margin indicates the possibility of profit growth. A negative net profit margin indicates the tendency to lose money. Therefore, a company’s net profit margin is an indicator of how much the company makes in profit and how much it loses in loss.
For a business to have a firm understanding of profitability, management needs to perform profit and loss analysis, which is referred to as the analysis of both positive and negative margins. The most common of these profitability ratios is the operating margin, which compares cash inflows or expenditures against revenues earned. Another profitability ratio, the gross profit to sales ratio, compares profit earned per unit to sales per unit. A third profitability ratio, the gross profit margin, compares profit earned on gross sales to the actual cost per sale. These three ratios are the most widely used profitability ratios in corporate business plans.
Amazon, one of the largest online retail stores, has its own profitability metrics. The gross profit margin is calculated as net income divided by gross profit. Net income refers to all revenue including fees, expenses, and profit. The gross profit margin, then, reflects the discrepancy between revenue and expense.
Net profit is more straightforward to calculate since it is all revenue minus expenses. Because it does not include expenses, this is considered to be the purest form of profitability measurement. The lower the figure, the more profitability is diluted by the fact that there are costs involved in generating the revenue. A higher figure, then, represents a more accurate representation of profitability.
You may also want to include the gross profit margin, cost of goods sold, and economic profits provide in your overall profitability measurement. The gross profit margin reflects the total expenses and revenue realized from sales. The cost of goods sold represents the direct cost of production, while the economic profits provide an estimate of what your direct costs and revenue will be if sales reach a preset level. Many investors prefer to invest in companies with high percentages of gross and economic profits provide. They feel that high percentages provide the best possible long term value.
A company’s profitability is determined by many factors, not the least of which are gross and economic profits provide. If you are starting a new venture, it is important to determine these figures as soon as possible. You may want to use the numbers for your operational funding. In order to reach a desired profitability level, you may have to sell at a higher price or close your business down completely. This will affect your capital budget, which affects your bottom line.