What Is Profit? (With 3 Important Profit Equations)

Updated February 3, 2023

Most businesses are for profit, meaning the ability to earn a profit after paying expenses is a key function of the organization. Earning a profit is a sign that a company is successful and can continue to grow. Learning more about the different aspects of profit can help you deepen your understanding of business management techniques.

In this article, we define profit, share reasons its important, explain how it compares to growth, describe different types of profit, and share tips for increasing profit.

What is profit?

Profit is the remaining revenue, also known as income, left after a company has accounted for all expenses. In small businesses, the profit usually goes directly to the company's owner or owners. Publicly owned and traded corporations pay out a certain amount of profit to stockholders in dividends. A business owner can keep the money or reinvest it into the company to encourage growth and more profit.

Why is profit important?

Often, earning a profit is the company's primary goal. Here are some reasons that profit is important to a business:

It reassures investors

A positive bottom line shows that the company is healthy and performing well. Seeing a positive profit report for a company they support can reassure investors they made a wise choice when they invested in the company. Since increased profits usually mean increased stock dividends for investors, the company's ability to make a profit directly benefits them. When a company shows profits quarter after quarter, investors may be less likely to divest their stocks, ensuring continued support for the company.

It increases a company's stock value

The stock market functions based on reported earnings and forecasted earnings from large public companies. Every quarter, companies announce their earnings or profits. Generally, if a company's earnings are good, its stock value goes up. Companies may also report measures to increase profitability as part of their future earnings forecast, which can also positively impact their company's stock value.

It provides for growth

Profit is capital that companies can use for a variety of purposes, like maintaining the workplace or equipment, replacing or upgrading vehicles or other high-cost items, or investing in new products, services or employees. By increasing its production or staff, a company can continue to build its market share and increase its profits even more. With strong profits, businesses can expect to continue flourishing.

Profitability vs. growth

Company leaders and external stakeholders may consider whether profit or growth is a better indicator of a company's health. Profitability, indicated by a positive bottom line, means that the company is earning more than it spends. It's a result of the company's operations and means that the company has a stable core function. Growth is a result of corporate decisions to expand, either by hiring more employees, diversifying products or moving into new markets.

Companies that are profitable, but not growing, might not offer investors the opportunity to earn large returns, while a company that grows too fast carries the risk of loss for investors. Investors typically consider both profitability and growth trends when deciding where to place their money. A company with a history of profit and an ambitious growth plan might be an ideal investment opportunity.

Types of profit

Income statements list three primary types of profit. Each type of profit gives company leadership and other stakeholders valuable insight into the health of the company. Here are the three main types of profit:

1. Gross profit

Gross profit is usually the first type of profit listed on the income statement, and often the highest figure. Gross profit is the company's revenue minus the cost of goods sold, or COGS. The gross profit helps companies see how much money they've made after accounting for the direct costs associated with creating their product or service. Here's a formula to calculate gross profit:

Gross profit = Sales revenue - cost of goods sold

2. Operating profit

Operating profit is below gross profit on the income statement. It accounts for both the COGS and the cost of operating expenses. The operating profit helps businesses evaluate how direct costs, like labor and machinery, and indirect costs, like building rent and utilities, detract from profit. To calculate operating profit, use this formula:

Operating profit = Gross profit - operating costs

3. Net profit

Net profit is the final profit calculation on the income statement, also known as the bottom line. Net profit is the remaining revenue after accounting for every business expense, including taxes and interest. The bottom line truly indicates how healthy a business is by showing how much revenue remains after paying all expenses and costs. Here's a formula you can use to calculate net profit:

Net profit = operating profit - tax and interest costs

What is a profit margin?

A profit margin is a measurement of how effectively a company uses its profits. This value usually takes the form of a ratio and can apply to gross, operating or net profit. To determine profit margin, divide either the gross, operating or net profit by the total revenue. High profit margin ratios indicate significant profit per revenue dollar, whereas low profit margin ratios indicate poor profit per revenue dollar.

External stakeholders, like investors, can use profit margins to compare the value of different-sized companies. For example, a large business may have much higher profits than a small business, but a small business may have a higher profit margin. This means that the more efficient small business might be a more profitable investment since investors might get a higher dividend per share when the company grows.

How to increase profit

Often, businesses are looking for ways to improve their net profit. Companies can take several approaches to increase their profits:

1. Increase revenue

Companies might increase revenue to boost their net profit, since more revenue translates into higher profits, provided operating costs remain stable. To increase revenue, a company might raise prices if market research shows that the company's core consumer audience is able and willing to pay higher prices. The company's product development team might diversify the company's offerings, enticing customers to purchase a larger number of goods from the company. Finally, marketers might expand their efforts to find new customers, who provide revenue.

2. Cut costs

Another method of increasing profits is cutting costs. Companies can assess and minimize direct and indirect costs to reduce expenses, which means that more of the company's revenue translates into profit. Here are two main types of costs that company leadership teams might evaluate:

Direct costs: These costs are expenses related specifically to the development of the product or service. Direct cost examples include labor and materials.
Indirect costs: Also called overhead, indirect costs include expenses related to running the business, but not specifically to the product or service sold. Indirect costs include rent or mortgage on the workplace and utilities like water and electricity.

3. Remove products

Sometimes companies sell a large variety of products or services. For those businesses, one method for increasing profits is removing products or services that do not sell well. Discontinuing poor sellers can decrease production costs and allow the company's manufacturing and product development teams to focus on more profitable products, eventually improving the bottom line.

4. Reduce or outsource inventory

Holding inventory can be costly. Depending on what the company sells, inventory storage may require a separate building and extra employees. Reducing the amount of stock the company keeps on-site can reduce costs and improve net profits. Some companies contract with third-party fulfillment companies, who provide storage and logistics support for a cost. Because these firms already have warehouse space and logistics experience, they can often offer storage and shipping for less money than the company spends on in-house inventory management.