Profitability (Cambridge International IGCSE Business)

The concept of profitability

• Profitability is the ability of a business to generate profit compared to the revenue it earns, the assets it uses, or the capital invested

  • It is a measure of how effectively a business converts sales revenue into profit
  • It is a measure of how well capital resources invested in the business generates profit

• Profitability is expressed in percentage form, which allows comparison of performance over time and with other businesses

• Several stakeholders are interested in profitability

  • Investors look carefully at profitability when deciding which business to invest in. The higher the level of profitability, the higher their rewards are likely to be
  • Directors and managers consider profitability when assessing business success and determining future objectives and strategy
  • Employees may consider profitability as justification for requesting higher wages or better working conditions

Exam Hint Don’t confuse profit with profitability – profit is the absolute amount earned, while profitability shows how efficiently a business turns revenue into profit. Examiners often test this distinction

Gross profit margin

• The gross profit margin shows the proportion of revenue that is turned into gross profit

  • It is calculated using the following formula and is expressed as a percentage

$\mathrm{Gross} \mathrm{profit} \mathrm{margin}=\frac{\mathrm{Gross} \mathrm{profit}}{\mathrm{Sales} \mathrm{revenue}}\times100$

• In general, the higher the gross profit margin, the better

  • It demonstrates that a business is effectively adding value

Worked Example Head to Toe Wellbeing’s revenue in 2024 was $124,653. Its gross profit was $105,731

Calculate Head to Toe Wellbeing Ltd’s gross profit margin in 2024.

(2)

Step 1: Substitute the values into the formula

$\text{Gross} \text{profit} = \frac{Gross \text{profit} }{Sales revenue} \times 100

= \frac{$ 105 , 731}{ $ 124 , 653 }

= 0.8482$ [1]

Step 2: Multiply the outcome by 100 to find the percentage

$= 0.8482 \times 100

= 84.82 %$ [1]

• 84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2024

Ways to improve the gross profit margin

Increase sales revenue

• Raise prices

  • If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater

• Sell premium products

  • If customers are willing to spend money on these goods, the business could earn more profit per item sold

• Price tactics

  • Use price tactics to encourage higher quantity or more frequent purchases
  • E.g. 'Buy one get one half price' doubles the number of items a customer purchases, increasing revenue

• Increase marketing activities

  • Engage in more marketing activities to increase sales volume

Reduce direct costs

• Direct costs are costs that can be completely attributed to the production of a specific good or services

  • Reduce variable costs

    • Source cheaper materials, negotiate with suppliers or purchase in bulk
    • Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products
    • Buying stock in greater quantities may require more storage space, which could reduce the impact of the cost savings

  • Reduce wastage of raw materials and components

Profit margin

• The profit margin shows the proportion of revenue that is turned into profit before interest and tax

  • It is calculated using the formula below and the outcome is expressed as a percentage

$\text{Profit margin =}\frac{\mathrm{Profit}}{\mathrm{Sales} \mathrm{revenue}}\times100$

• In general, the higher the profit margin, the better
• It demonstrates that a business is effectively managing expenses

Worked Example Head to Toe Wellbeing’s revenue in 2024 was $124,653. Its profit before interest and tax was $65,864

Calculate Head to Toe Wellbeing Ltd’s profit margin in 2024.

(2)

Step 1: Substitute the values into the formula

$\text{Profit \text{margin} = } \frac{Profit}{Sales revenue} \times 100

= \frac{$ 65 , 864}{$ 124 , 653}

= 0.5284$ [1]

Step 2: Multiply the outcome by 100 to find the percentage

$= 0.5284 \times 100

= 52.84 %$ [1]

• In 2024,52.84% of Head to Toe Wellbeing’s revenue was converted into profit

Ways to improve the profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)

  • Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies

    • Reducing staffing levels may affect staff morale and negatively affect productivity
    • Relocation costs can outweigh some of the benefits of moving to a cheaper location
    • Replacing inefficient or outdated equipment may require staff training

Return on capital employed (ROCE)

• Return on capital employed (RoCE) measures how effectively a business uses the capital invested in the business to generate profit

  • It is calculated using the formula below and is expressed as a percentage

$\mathrm{Return} \mathrm{on} \mathrm{capital} \mathrm{employed}=\frac{\mathrm{Profit}}{\mathrm{Capital} \mathrm{employed}}\times100$

• RoCE can be compared over time and with direct competitors

  • It can also be compared with other potential capital investments, such as savings rates
  • It is less useful to compare with businesses in contrasting industries

Interpreting the RoCE

• With RoCE, the higher the rate the better

  • This indicates that the business is profitable and using capital efficiently

    • Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved
    • A ROCE of at least 20 percent is usually a good sign that the company is in a good financial position

Exam Hint In the exam, the capital employed figure is usually provided for you

If required, it is calculated using the formula

$\mathrm{Capital} \mathrm{employed}=\mathrm{Non}-\mathrm{current} \mathrm{liabilities}+\mathrm{Equity}$

Worked Example The table shows an extract from the company accounts of Keals Cosmetics.

Non-current Liabilities	€1.5 million
Revenue	€7 million
Equity	€15.4 million
Profit	€2.2 million

**Calculate **Keals Cosmetics' return on capital employed.

(3)

** Step 1: Calculate capital employed**

$Capital \text{employed} = Non - \text{current} \text{liabilities} + Equity > > Capital \text{employed} = \text{€} 1.5 \mathrm{m} + \text{€} 15.4 \mathrm{m} > > Capital \text{employed} = \text{€} 16.9 \mathrm{m}$ [1]

Step 2: Divide profit by capital employed

RoCE = ( Profit before interest and tax)/(Capital employed) x 100 > > = (\text{€} 2.2 m)/(\text{€} 16.9 m) x 100 > > = 0.13 > > [1]

Step 3: Multiply the result by 100 and express the outcome as a percentage

$= 0.13 \times 100 = 13 \%$****[1 ]**

• Capital employed in Keals Cosmetics has generated a return of** 13%

Ways to improve RoCE

• To increase the RoCE, a business can

  • Increase the level of profit generated without introducing new capital into the business
  • Maintain the level of profit generated whilst reducing the amount of capital in the business