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The Accounting Definition Of Profit

Ask an accountant to define profit and he or she will say something like:

“Profit is the difference between revenue and costs in a defined period of time.”

In some businesses revenue may be called sales, turnover, fees receivable or premiums receivable while costs may sometimes be called expenses.

I’m going to be using sales and costs as my standard terms during this course.

It is important to appreciate that profit is a flow over time.

A statement “Profit is 100,000 pounds or dollars” is meaningless.

The statement “The profit for the month is 100,000” is not the same as “the profit for the year is 100,000”.

It’s obvious but I’ve heard plenty of examples of miscommunication and confusion between people talking about profit for the month, quarter and year.

There are also different levels of profit which mean different things in the Profit & Loss Account (link).

For example:

Gross Profit is usually sales minus the costs of sales (or cost of goods sold or COGS for short). This can be an important measure but we will see in the next module, Gross Profit can be very loosely defined and lose its relevance.

Operating Profit is the profit left over after deducting all the normal costs of a business but not the costs of financing. It allows comparisons across businesses that are independent of their finance structure and can therefore be useful for investors.

For public companies, Operating Profit also often reported before and after what I call “funnies” and what are more correctly known as exceptional items.

When I was Finance Director of a manufacturing business in the early nineties, we had a fire in the factory.

In that afternoon we made more profit from the insurance claim – because of the difference between the book value of the assets destroyed and how much we could claim back – than we did in six months of trading.

The profit from the insurance claim was an exceptional item – it was big and not expected to happen again.

To include it in our normal trading profits would have given the wrong impression of our performance. We’d have been fooling ourselves and everyone else who saw our accounts.

The next important definition is Profit Before Tax. This is the profit after interest charges and any exceptional items have been deducted but before business taxes have been applied.

The profit at the bottom of the Profit & Loss Account is the Profit After Tax.

This is the amount left to increase the wealth of the shareholders, either by reinvesting in the business or to be taken out as dividends.

Return to P1M2 What Is Profit (link)

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