Lesson Personal Finance: Profit and Loss

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About Shruti_Mishra: I am a maths graduate from India and am currently persuing masters in Operations Research.

<A HREF="profit.wikipedia">Profit</A> forms the underlying motive of most of the businesses and even for small transactions, an individual likes to know if it was profitable for him. On the other hand, no one wants to make a <A HREF="loss.wikipedia">loss</A> on a transaction.

Simply put <A HREF="profit.wikipedia">profit</A> can be defined as the excess of <A HREF="revenue.wikipedia">revenue</A> over <A HREF="cost.wikipedia">cost</A>. Thus the formula for calculating the <A HREF="profit.wikipedia">profit</A> will be

<center>Profit = Revenue - Cost</center>

If <A HREF="revenue.wikipedia">revenues</A> is less than <A HREF="cost.wikipedia">cost</A>, then the result will be negative. In this case, the result actually is a <A HREF="loss.wikipedia">loss</A>. The formula for calculating loss (if revenue < cost) would be

<center> Loss = Cost - Revenue </center>

Example: Calculate the <A HREF="profit.wikipedia">profit</A> if the revenue is $400 and cost is $250.
Solution: Profit = $400 - $250 = $150

Basing any transaction decision on the basis of absolute <A HREF="profit.wikipedia">profit</A> value can be misleading. Consider a case where you have two types of transactions to chose from. The <A HREF="revenue.wikipedia">revenues</A> associated with them are $400 and $1000 respectively and the costs are $200 and $600. The <A HREF="profit.wikipedia">profits</A> can be calculated as $200 and $400 respectively. It would seem tempting to choose the second one. However, if you had only $600 to spend, then you can either go for 3 transactions of first type or 1 transaction of second type. You will make $600 in the first one and $400 in the second one. Thus for every $600 of cost you can make more <A HREF="profit.wikipedia">profit</A> in the first transaction.

A better method to compare transactions or evaluate profitability is thus profit margin. <A HREF="profit_margin.wikipedia">Profit margin</A> is defined as <A HREF="profit.wikipedia">profit</A> as a percentage of the <A HREF="revenue.wikipedia">revenues</A>, i.e.

<center>Profit Margin = Profit/Revenue = (Revenue-Cost)/Revenue = 1 - Cost/Revenue </center>

Consider the previous example. The <A HREF="profit_margin.wikipedia">profit margins</A> on the two transactions would be

Profit Margin(1) = 1 - $200/$400 = 50%
Profit Margin(2) = 1 - $600/$1000 = 40%

It can be seen that the first transaction is more profitable than the second one. For calculating <A HREF="profit.wikipedia">profit</A> and <A HREF="profit_margin.wikipedia">profit margin</A>, use the <A HREF="profit_calculator">profit calculator</A>.