▪ Concept of Profit

Analysis
PROFIT ANALYSIS ▪ Gross Profit
▪ Net Profit
PROFIT ANALYSIS
In managerial economics, profit analysis is a
form of cost accounting used for short run
decisions. A profit analysis widens the use of
info provided by breakeven analysis. An important
part of profit analysis is the point where total
revenues and total costs are equal. At this
breakeven point, the company does not experience
any income or any loss.
 LIMITATIONS OF PROFIT
ANALYSIS
▪ The profit analysis is a short run and marginal analysis which
presumes the unit variable costs and the unit revenues to be
constant.

▪ Profit analysis is strictly historical in nature.

▪ Profit analysis does not examine the constraints within a

business to determine what is holding it back from generating
more profits.

▪ Profit analysis does not account for where products are

located in their life cycles.
 COMPONENTS OF PROFIT
ANALYSIS - REVENUE, COST &
❖ PROFIT
REVENUE - The total monetary value of the goods or services
that a business sells.

❖ COST - The collective expenses incurred to generate revenue

over a period of time, expressed of monetary value.

Variable Cost – Expenses that change as the volume of

sales changes.

Fixed Cost – Expenses that remain the same regardless of

the volume of sales or that remain the same within a
certain range of sales volumes.
COMPONENTS OF PROFIT
ANALYSIS - REVENUE, COST &
PROFIT
PROFIT – The difference between the revenue & cost
when revenue exceeds the cost incurred in operating the
business.

LOSS – The difference between the revenue & cost when

the cost incurred in operating the business exceeds
revenue.
ILLUSTRATION 1
The students need to determine whether they can
make a profit from a summer ice cream bar
business. They met the business owner of the ice
cream bar and told them that last summer he
charged $1.50 per ice cream bar & sold 36,000 ice
cream bars. He said that the cost of the ice cream
bars – wholesale purchase, delivery, storage & so
on – comes about $0.30 per bar. He also indicated
his other main costs – leasing the building,
license, local business association fee, &
insurance came to about P16,000.
 Unit Sold 36,000
SP/u 1.50
Variable Cost 0.30
Fixed Cost 16,000

Revenue $ 54,000
Variable Cost (36,000 * 0.30) 10,800
Fixed Cost 16,000 26,800
Profit $ 27,200
The students are confident the summer business venture can make
money. They approach the owner of the building and learn that if
they want to reserve the right of first option to lease the building
over the summer, they will need to make a nonrefundable $6000
deposit that will be applied to the lease. They proceeded to make
that deposit.

A few weeks later, all three students were unexpectedly offered

summer business internships at a large corporation. Each student
would earn $10,000. However, the work site for the internships is
far from the beach and they would be in an office all day. They now
must decide whether to accept the internships and terminate their
plan to run a business at the beach or turn down the internships.
 ECONOMIC VERSUS
ACCOUNTING MEASURES OF
COST PROFIT
▪ The discipline of accounting provides guidelines for the
measurement of revenue, cost, and profit. Having analyses
based on generally accepted principles is important for
making exchanges in our economy
▪ Costs as measured according to accounting principles are
not necessarily the relevant measurements for decisions
related to operating or acquiring a business.
▪ There are other business costs relevant to decision
making that may not be considered as costs from the
perspective of accounting standards.
 KEY TAKEAWAYS
Explicit Cost: A direct payment made to others in the course of running a
business, such as wages, rent, and materials, as opposed to implicit costs,
which are those where no actual payment is made.

Implicit Cost: Is the cost of choosing one option over another. This
represents a company’s opportunity cost of utilizing resources it already
owns.

Economic Profit: The difference between the total revenue received by the
firm from its sales & the total opportunity costs of all the resources used
by the firm.

Economic Profit = Total Revenue – (Explicit cost + Implicit cost)

 KEY TAKEAWAYS
Accounting Profit: The difference between revenue and
accounting costs.

Opportunity Cost: The value of the next alternative

forgone.

Sunk Cost: Money that has been spent in the past and should
not be taken into account in the current decision.

Normal Profit: Occurs when the difference between a

company’s total revenue and combined explicit and implicit
costs are equal to zero.
The students’ time has an opportunity cost of $30,000.
This should be added to the earlier fixed cost of
$16,000, making an economic fixed cost of $46,000, a
total economic cost of $56,800, and an economic loss of
$2800.

Assuming the fixed cost of the business was the same as

for the prior operator, the students would have a
$16,000 accounting fixed cost to report on a tax return.
From the perspective of economic costs, only
$10,000 is really still avoidable by not
operating the business. The remaining $6000 is
gone regardless of what the students decide.

If the students’ other costs & revenue were

identical to the previous year, they would have
economic cost of just $50,800 & an economic
profit of $3200.
Revenue $ 54,000
Variable Cost $ 10,800
Fixed Cost 16,000
Non-refundable Cost (6,000)
Opportunity Cost 30,000 50,800
Economic Profit 3,200
Suppose that Suzie owns a bagel shop called Suzie’s
Bagels,
Averagewhich generates an average of $150,000
Revenue revenue
$150,000
each year. annual
Employee Also suppose that Suzie
salaries has two employees,
$40,000
each of whom she
Suzie annual salarypays $20,000 per year,
40,000and Suzie takes
an annual salary of $40,000. Suzie also pays $20,000
Rent 20,000
annually in rent and $30,000 annually for ingredients
Supplies 30,000 130,000
and other supplies. After meeting with her financial
Opportunity
advisor, Suzie Cost
learns that based on her business20,000
and her
Normal Profit
individual skills, the estimated opportunity cost0 of
operating Suzie’s Bagels full time is $20,000 each
year.
REVENUE FUNCTION
There is a relationship between the volume or quantity
created and sold and the resulting impact on revenue,
cost, and profit. These relationships are called the
revenue function, cost function, and profit function.
These relationships can be expressed in terms of tables,
graphs, or algebraic equations.

Revenue Function: The product of the price per unit

times the number of units sold; R = P*Q.
In a case where a business sells one kind of product
or service, revenue is the product of the price per
unit times the number of units sold. If we assume ice
cream bars will be sold for $1.50 apiece, the equation
for the revenue function will be

R = $1.50Q ; where R is the revenue & Q is the

number of units sold
 COST FUNCTION
Cost Function: The sum of fixed cost and the product of
the variable cost per unit times quantity of units
produced, also called total cost

C = F + V*Q.

C = $40,000 + $0.30Q ; where C is the total

cost.
PROFIT FUNCTION
Profit Function: The sum of fixed cost and the
product of the variable cost per unit times quantity
of units produced, also called total cost;
C = F + V*Q.

π = R – C = $1.20Q - $40,000

SP/u $ 1.50
VC/u 0.30
1.20
AVERAGE COST
Average Cost: The total cost divided by the quantity
produced; AC = C/Q.

▪ The relationship between average cost andquantity

is the average cost function

AC = C/Q = ($40,000 + $0.3Q)/Q = $0.3 + $40,000/Q = 1.41

GROSS PROFIT & NET
PROFIT
 BASIS GROSS PROFIT NET PROFIT
Definition The leftover profit after The residual income that an
deducting all the direct organization is left with
expenses from the after paying off all its
manufacturing process. expenses for a financial
period.
Objective To estimate a company’s To determine company’s
profitability. performance.
Advantage Controls excess costs. Shows a company’s
performance in a year.
Reliability It is difficult to make This is a true profit that a
financial decisions using company can use to make
gross profit as it does not business decisions for its
include expenses, taxes, & development.
interest on loans.
Credit Balance It shows the credit balance It shows the credit balance
of the trading account. of the profit & loss account.
Formula Gross Profit = Revenue – COGS Net Profit – Gross Profit –
Expenses
GROSS PROFIT METHOD
The gross profit method is based on the assumption that the rate
of gross profit remains approximately the same from period to
period & therefore the ratio of COGS to net sales is relatively
constant from period to period.

Basic formula under Gross Profit Method

GOODS AVAILABLE FOR SALE (GAS) xx

Less: Cost of Sales xx
Ending Inventory xx
GOODS AVAILABLE FOR SALE
The usual items affecting the GAS sre:

Beginning Inventory xx
Purchases xx
Add: Freight in xx
Total xx
Less: Purchases returns, allow. & discount xx xx
Goods available for sale xx
COST OF SALES
The Gross Profit Method is so called because the cost of sales
is computed through the use of the gross profit rate.

The cost of sales is computed as follows:

▪ Net sales multiplied by cost of ratio

This formula is used when the gross profit rate is based
ON SALES.
▪ Net sales divided by sales ratio
This formula is used when the gross profit is based ON
COST.
 GROSS PROFIT BASED ON
SALES
Beginning inventory 100,000
Net Purchases 500,000
Net Sales 700,000
Gross profit rate based on sales 40%

The ending inventory is computed as follows:

Beg. Inventory 100,000

Net purchases 500,000
Goods available for sale 600,000
Less: Cost of sales:
Net sales 700,000
Cost ratio 60% 420,000
Ending Inventory 180,000
Observe the following:

Amount Percent
Net sales 700,000 100%
Cost of sales 420,000 60%
Gross profit on sales 280,000 40%
 GROSS PROFIT BASED ON COST
Beg. Inventory 200,000
Net purchases 1,000,000
Net sales 1,260,000
Gross profit rate based on cost 40%

The ending inventory is computed as follows:

Beg. Inventory 200,000

Net purchases 1,000,000
Goods available for sale 1,200,000
Less: Cost of sales:
Net sales 1,260,000
Divided by sales ratio 140% 900,000
Ending inventory 300,000
Observe the following:
Amount Percent
Net sales 1,260,000 140%
Cost of sales 900,000 100%
Gross profit on cost 360,000 40%
Beg. Inventory 600,000
Purchases 2,530,000
Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000
Freight in 50,000
Sales 3,100,000
Sales return 100,000
Sales allowance 50,000
Sales discount 150,000

The ending inventory is computed under each of the following

assumptions:
▪ Gross profit rate is 25% on sales
▪ Gross profit rate is 25% on cost
GROSS PROFIT RATE based on sales

Beg. Inventory 600,000

Purchases 2,530,000
Add: Freight in 50,000
Total 2,580,000
Less: Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000 30,000 2,550,000
Goods available for sale 3,150,000
Less: Cost of sales
Sales 3,100,000
Less: Sales return 100,000
Net sales 3,000,000
Multiply cost ratio 75% 2,250,000
Ending inventory 900,000
*In computing “net sales”, the sales allowance & sales discount are
DISREGARDED.
GROSS PROFIT VS. NET PROFIT
Gross profit is your revenue
without subtracting your
manufacturing or production
expenses, while net profit is
your gross profit minus the cost
of all business operations and
non-operations. Your net profit
is going to be a much more
realistic representation of your
company's profits.