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Profit and Loss

We will start by looking at the terms 'profit' and 'loss'. Both these terms are concerned with the difference between the money a firm receives through selling its products (revenue) and the costs it has to pay to produce and sell those products.

• TR = Total Revenue. TR is found by multiplying price by the amount sold. (TR = P x Q)
• TC = Total Costs. This is all the costs involved in producing and selling a good or service. Costs can be fixed (which do not depend on the amount produced or sold) or variable (which depend directly on the amount produced or sold). (TC = FC + VC)

Profit can be negative - if it is, then we call it a loss.

• If TR is greater than TC over a period of time, the firm will make a profit.
• If TR is less than TC, the firm makes a negative profit or a loss.

Remember, profit is not the same as revenue!

Case Study: Sainsbury's

Making a loss does not mean that a firm will close down. Many very large firms make losses at some point in their history but do not immediately close down. Sainsbury's, for example, had a difficult time some years ago. The company has been going for over 130 years but in 1994 it announced that it had made a loss of £39 million for the first half of the year. In May 2006, the firm reported profits for 2005 of £267 million!

Sometimes you will see news reports of firms reporting a 'collapse in profits' The headlines might make things sound bad but there might be very good reasons for the fall in profits, which may not always be a 'bad thing' as such. We need to think a little about what lies behind the headlines and what we really mean by 'profit'.

Let us take the Sainsbury's example. In 2004, Sainsbury's made a profit but also a loss. That might sound very confusing. The company made a profit on its sales - the food and groceries that we bought from them. However, the company also had a number of extraordinary costs that it had to pay. Since the mid-1990s, Sainsbury's had been investing in IT systems and new distribution depots to try to improve efficiency and service. Unfortunately, these had not worked as they had planned and so in 2004, they had to spend more money to attempt to sort out the problem. This meant their costs were much higher than they would normally have been. It was these extraordinary costs that had pushed them into loss.

If the loss was worse the next year and continued to get worse in subsequent years then Sainsbury's really would have been in trouble. Firms can only cope with losses for a certain period of time; if they do not or cannot do anything to turn the situation around, they will be forced to close.

From our profit formula, we can tell a number of things:

We can see from this that there are quite a lot of things that can affect the profit a firm makes. For Sainsbury's, the problem for them in 2004 was not that there was anything really wrong with their revenue but it was the costs that really made a difference.

This background information and the importance of understanding how profit is made are important in understanding the idea of break-even.

Break-even is the level of output at which the firm is just earning enough in revenue to just cover its costs - at the break-even output, the business makes neither a profit nor a loss. As we mentioned earlier, break-even is a planning tool: it allows the firm to be able to see what might happen if it changed some of the factors that influence profit.

We are going to use the scenario of the fruit stall introduced in another resource to look at break-even in more detail.

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