Profit and loss
Contents: 8 sections
What profit is
Profit is what is left of a business's revenue once all of its costs have been taken off. Cambridge publishes the formula in two forms and both are examinable.
Profit = total revenue - total costs
Profit = gross profit - expenses
Revenue is the value of what the business sold, not the number of items.
Revenue = selling price per unit x number of units sold
A bakery sells 6,500 cakes at $40 each.
Revenue = 40 x 6500 = $260,000
If revenue is smaller than total costs, the business has made a loss. There is no separate formula for a loss; it is a profit with a minus sign, and an answer of -$8,000 is a loss of $8,000.
One boundary is worth fixing early. Profit is not the same as the cash in the bank, because a sale is counted on the day it is made even if the customer pays three months later, and buying a machine takes cash out without appearing as a cost in one go.
Why profit matters
0264 gives four reasons, and questions often ask for two of them with an explanation attached.
| Reason | What it means for the owner |
|---|---|
| Reward for risk-taking | The owner put their own money in and could have lost it. Profit is the return for carrying that risk, and there is no wage that compensates for it |
| Source of finance | Profit kept in the business (retained profit) pays for expansion without borrowing, without interest and without giving anyone a share of the ownership |
| Measure of success | It shows whether the business is doing what it exists to do, and lets this year be compared with last year or with a competitor |
| Attract investors | Banks, venture capital firms and share buyers all look at the profit record before they commit. A business with rising profit borrows more cheaply and raises money faster |
Do not stop at naming one of these. "Profit is a source of finance" is one knowledge mark; "profit is a source of finance, so the bakery can pay for the second oven out of last year's earnings instead of taking a loan that would cost it $4,800 a year in interest" is the point taken forward to a consequence, which is where the analysis mark sits.
The statement of profit or loss
A statement of profit or loss sets out revenue, the costs taken off it, and the profit left at the end, for a period of a year. Older textbooks and older papers call the same document an income statement; 0264 calls it a statement of profit or loss, and that is the heading you will meet on the question paper.
| Feature | What it is |
|---|---|
| Revenue | The value of goods and services sold during the year |
| Cost of sales | The direct cost of the goods actually sold: materials and the cost of buying in the stock that was sold |
| Gross profit | Revenue minus cost of sales. What is left before any running costs |
| Expenses | The running costs that are not part of making the product: rent, salaries, insurance, advertising, electricity |
| Profit | Gross profit minus expenses. What is left for the owners |
Gross profit = revenue - cost of sales
Profit = gross profit - expenses
The line between cost of sales and expenses catches people out. Flour and the wages of the bakers who mix it are cost of sales, because they rise and fall with the number of cakes made. The rent of the office and the salary of the accountant are expenses, because they are the same whether the bakery sells 6,000 cakes or 8,000.
The 0264 syllabus states that candidates will not be assessed on constructing a statement of profit or loss. You will be given one and asked to calculate a missing figure from it, or to make a decision using it.
A worked statement
Statement of profit or loss for the year ended 31 December.
| $ | |
|---|---|
| Revenue | 480,000 |
| Cost of sales | 288,000 |
| Gross profit | 192,000 |
| Expenses | 120,000 |
| Profit | 72,000 |
Gross profit = revenue - cost of sales = 480000 - 288000 = $192,000
Profit = gross profit - expenses = 192000 - 120000 = $72,000
Checking by the other published form: total costs = cost of sales + expenses = 288000 + 120000 = $408,000, so profit = total revenue - total costs = 480000 - 408000 = $72,000. The two routes must agree, and running the second one is the fastest way to catch a slip.
Calculating from a statement
Questions rarely hand you the two figures you need in the order you need them, so practise working in every direction.
Straight through. Revenue is $260,000, cost of sales is $150,000 and expenses are $70,000.
Gross profit = 260000 - 150000 = $110,000
Profit = 110000 - 70000 = $40,000
Backwards to cost of sales. Revenue is $260,000 and gross profit is $110,000.
Cost of sales = revenue - gross profit = 260000 - 110000 = $150,000
Backwards to expenses. Gross profit is $110,000 and profit is $40,000.
Expenses = gross profit - profit = 110000 - 40000 = $70,000
From units. The business sold 6,500 units at $40 and its costs were $220,000 in total.
Revenue = 40 x 6500 = $260,000
Profit = 260000 - 220000 = $40,000
Write the formula, then the substitution, then the answer with a dollar sign. A correct number with no working still scores, but a wrong number with visible working can pick up the method mark, and a number with no unit invites the examiner to wonder whether you knew what you had calculated.
Making decisions from a statement
Two years side by side is where the marks are, because a single year says almost nothing.
| Last year $ | This year $ | |
|---|---|---|
| Revenue | 400,000 | 480,000 |
| Cost of sales | 232,000 | 288,000 |
| Gross profit | 168,000 | 192,000 |
| Expenses | 98,000 | 120,000 |
| Profit | 70,000 | 72,000 |
Revenue rose by 480000 - 400000 = $80,000, which is 80000 / 400000 x 100 = 20%.
Profit rose by 72000 - 70000 = $2,000, a rise of under 3%.
That gap is the whole story. Selling a fifth more brought in almost nothing extra for the owner, because cost of sales rose by 288000 - 232000 = $56,000 and expenses rose by 120000 - 98000 = $22,000, so $78,000 of the extra $80,000 was eaten by costs.
Now the decision. If the extra sales were won by cutting the selling price, the business is working harder for the same money and should think again about the price. If the extra expenses were an advertising campaign or a second delivery van, they may be a one-off that pays back next year, and holding the line makes sense. Saying which of those it is, using the evidence in the stem, is the evaluation mark. Saying "profit has gone up so the business is doing well" throws it away.
Common mistakes
- Using the word profit when you mean revenue. Revenue is everything that came in; profit is what survived the costs.
- Taking expenses off revenue instead of off gross profit.
- Adding gross profit and profit together. Profit is part of gross profit, not an extra amount beside it.
- Putting the purchase of a machine into the statement as a cost, or a bank loan into it as revenue. Neither belongs there.
- Calling a wage an expense without checking. Production wages are part of cost of sales; office salaries are expenses.
- Giving a bare number with no dollar sign, or a percentage where the question asked for an amount.
- Saying a business with a profit must have money in the bank.
- Answering "why is profit important" by saying the owner can spend it, and stopping there. Name the reason 0264 gives and take it forward.
- Comparing two years by looking at profit alone, when revenue and both cost lines have moved as well.
What the syllabus asks for on this topicSyllabus points
Syllabus points
- Explain what profit is, and calculate it as total revenue minus total costs, or as gross profit minus expenses.
- Explain the importance of profit to private sector businesses: reward for risk-taking, source of finance, measure of success and attracting investors.
- Identify the main features of a statement of profit or loss: revenue, cost of sales, gross profit, expenses and profit.
- Make simple calculations from a statement of profit or loss, including revenue, cost of sales, gross profit, expenses and profit.
- Make decisions based on simple statements of profit or loss.
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