What Is Profit and How Does It Work?

Two Foolproof Ways to Increase Profit

profit margin
Gross profit allows auto makers to see which model is most profitable. Photo: Getty Images

Profit is the revenue remaining after all costs are paid. Companies use profit to calculate their tax obligation and the dividend they can pay to shareholders. When expenses are higher than revenue, that's called a loss. 

Type of Profit

Businesses use three types of profit to examine different areas of their companies.

1. Gross profit subtracts variable costs to revenue for each product line. Variable costs are only those needed to produce each product, like assembly workers, materials, and fuel.

It doesn't include fixed costs, like plants, equipment, and the human resources department. Companies compare product lines to see which is most profitable.

2. Operating profit includes both variable and fixed costs. Since it doesn't include certain financial costs, it's also commonly called EBITA. That stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It's the most commonly used, especially for service companies that don't have products.

3. Net profit includes all costs. It's the most accurate representation of how much money the business is making. On the other hand, it may be misleading. For example, if the company generates a lot of cash, and it's invested in a rising stock market, it may look like it's doing well. But it might just have a good finance department, and not be making money on its core products.

Profit Formula

Profit is calculated by the following formula:

π = R - C

  • Where π (the symbol for pi) = profit
  • Revenue = Price (x)
  • C = Fixed  cost, such as cost for a building +Variable cost, such as the cost to produce each product (x) 
  • x = number of units.

For example, the profit for a kid selling lemonade might be:

π = $20.00 - $15.00 = $5.00

  • R = $0.10 (Price for each cup) (200 cups) = $20.00
  • C =  $5.00 (for wood to build lemonade stand) + $.05 (for the cost of sugar and lemons per cup)(200 cups sold) = $5.00 + $10.00 = $15.00

Profit Motive

The purpose of most businesses is to increase profit and avoid losses. That is the driving force behind capitalism and the free market economy. The profit motive drives businesses to come up with creative new products and services. They then sell them to the most people. Most important, they must do it all in the most efficient manner possible. Theorists Milton Friedman and Friedrich Hayek argue that the profit motive is the most efficient way to allocate economic resources. According to them, greed is good.

Two Foolproof Ways to Increase Profit

There are only two ways to increase profit. The first, and best, is to increase revenue. That can be done by  raising prices, increasing the number of customers, or  expanding the number of products sold to each customer.

Raising prices will increase revenue if there is enough demand. Customers must want the product enough to pay higher prices. Increasing the number of customers can be expensive. It requires more marketing and sales. Expanding the number of products sold to each customer is less expensive.

The trick is to understand your customer well enough to know which related products they might want.

The second way to increase profit is to cut costs. That is a good method up to a point. It makes a company more efficient, and therefore more competitive. Once costs are down, the business can reduce prices to steal business from its competitors. It can also use this efficiency to improve service, and react more quickly.

The biggest budget line item is usually labor. Companies that want to quickly increase profits will lay off workers. This is dangerous. Over time, the company will lose valuable skills and knowledge. If enough companies do this, it can lead to an economic downturn. That's because there aren't enough workers earning good wages to drive demand. The same thing happens when businesses outsource jobs to low-cost countries.

How Profit Drives the Stock Market

Profits are also known as earnings. Public corporations that are listed on the stock market announce them every three months in quarterly reports. That occurs during earnings season. They also forecast future earnings.

Earnings season significantly affects how the stock market does. If earnings are higher than forecast, the company's stock price rises. If earnings are lower than expected, prices will drop.

Earnings seasons are especially important to watch in the transition phases of the business cycle.. If earnings improve better than expected after a trough, then the economy is coming out of the recession. It's headed into the expansion phase of the business cycle. Poor earnings reports could signal a contraction and recession