What Is Profit and How Does It Work?

Understand How It's Used, and Why It Drives Stock Prices

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

Definition: Profit is how much of a company’s revenue is left over after all expenses (costs) are paid. When expenses are higher than the revenue, that's known as a loss. 

Businesses use three types of profit to examine different areas of their companies. The first is gross profit, which 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. It's useful to compare product lines to see which is most profitable.

The second is operating profit, which includes both variable and fixed costs. Since it doesn't include certain financial costs, it's also known as EBITA. That stands for Earnings Before Interest, Tax, Depreciation and Amortization. It's usually the most commonly used, especially for service companies that don't have products.

The third type is net profit. It includes everything, so 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, the company may look like it's doing well. However, it might just have a good finance department, and not be making money on its core products.

Profit Formula

Profit can be 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 = $.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 profitability and avoid losses. There are only two ways to increase profit. The first, and best, is to increase the top line number or revenue. That can be done by 1) raising prices, 2) increasing the number of customers, or 3) expanding the number of products sold to each customer. Raising prices will increase revenue if there is enough demand, and customers want the product enough to pay higher prices.

Increasing the number of customers can be expensive, as it requires more marketing and sales. Often, it's less expensive to sell related products to existing, loyal customers who already like your brand.

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,  usually making it more competitive. It can then lower prices to steal business from its competitors. It can also use this efficiency to improve service, and react more quickly.

However, the biggest budget line item is usually labor.

Companies that want to quickly increase profits will lay off workers. 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 with good wages to drive demand. For more of these adverse effects, see How Jobs Outsourcing Affects the U.S. Economy.

This profit motive drives businesses to come up with creative new products and services. They then sell them to the most people. Most important, thye must do it all in the most efficient manner possible.

How Profit Drives the Stock Market

Profits are also known as earnings.

They are usually reported by corporations on a quarterly basis (every three months). Earnings season is when public companies (listed on the stock market) report on how profitable they were during the last quarter. They also forecast future earnings.

Earnings season is important because it significantly affects how the stock market does. If earnings are good and more important, above forecast, then stock prices will typically rise. If earnings are lower than expected - if companies miss their earnings - then stocks 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. For more, see Business Cycle Phases. Article updated October 21, 2015.