Profitability

For a business to be profitable, the income needs to be greater than the expenditure incurred to create that income. It is usually measured over a time period because costs and income rarely align unless you’re in the drop shipping business.

Gross profit is the measure of income less variable costs (the profitability of the product or service itself). It is used to compare different products and to assess the impact of changing production and sales volumes.

EBITDA is the measure of gross profit less the fixed running costs of the business. It is the basis for company valuations and is most closely analysed when looking at cashflow.

Net profit for tax includes deductions for the depreciation and amortisation (and excludes non tax-deductible expenditure as well as non tax-assessable income). This is the end of year position on which dividends and taxation is based.

What measure is used depends upon the purpose of calculating it.

Care should be taken when assessing profitability to ensure that cost of inventory has been taken into account (stock at start of period + stock purchased – stock at end of period), and that the cost of sales (sold product plus unsold product) is matched with the correct fixed and variable costs.

For manufacturing businesses, production and delivery lags can cause incorrect profitability calculations as time periods rarely nicely align with calculation periods. Minimum order quantities and production run volumes can inflate costs that are not generating income until a later time.