Before we can look at how to improve profitability, we first need to understand what profits and ‘profitability’ are.
Profit is the amount of money your business makes over a period of time, less the expenses for that same period. For tax reasons, it is calculated on an annual basis, usually from April one year to March the following year. Profit can be understood using the following formula:
In other words, your profit is what you have left over after subtracting all your expenses from what you earn from sales. This means that there are two basic ways to increase profits: you can increase sales revenue or decrease costs. To increase sales revenue, you can:
- increase product prices, and / or
- increase quantity sold.
An increase in product prices often (but not always) leads to a decrease in the quantity sold. That is, when you increase your prices, sooner or later, some customers will stop buying from you. This means you can only increase profits through increasing prices if the increased revenue per sale offsets any decrease in quantity sold.
The term profitability refers to the amount of profit you get compared to the amount of sales you make, or compared to the size of the business. Profitability is not the same as profits. One of the main ways to increase business profits is to sell more, whereas improving profitability means making more profit from the resources you have and sales you make – you don’t have to sell more to be more profitable.