The profit formula is the calculation used to determine the percentage profit generated by a business. The concept is used to judge the ability of an entity to set reasonable price points, manufacture goods cost-effectively, and operate in a lean manner. The profit formula is stated as a percentage, where all expenses are first subtracted from sales, and the result is divided by sales. The formula is:
(Sales - Expenses) ÷ Sales
For example, a business generates $500,000 of sales and incurs $492,000 of expenses. The result of its profit formula is:
($500,000 Sales - $492,000 Expenses) ÷ $500,000 Sales
= 1.6% Profit
The results of the profit formula will vary by industry. If an industry is monopolistic or has strong legal protections, its results will be better than one in which sales are commoditized and competition is more intense.
There are several issues with the profit formula to be aware of. These are so significant that it would be unwise to solely rely upon it as the basis for an evaluation of a business. The issues are:
- Non-cash nature. The profit figure upon which the formula is based includes such non-cash expenses as depreciation and amortization, and so tends to understate the cash flows generated by a business. This issue is only a problem if the accrual basis of accounting is used.
- One-time revenues and expenses. In any given period, the reported profit figure may contain an unusual spike or decline in revenues or expenses, so that the outcome can be considered out of the ordinary. This issue can be mitigated by reviewing the profit formula on a trend line.
- Can be manipulated. The accounting standards allow company managers some discretion in determining the size and timing of expense recognition in certain cases. This can result in significant swings in the amount of profit reported.
- Asset usage. There is no consideration of the amount of assets required to operate a business. For example, management could require an enormous amount of capital in order to produce an average profit.