How do I calculate profit? | Calculating profit margins

This simplest profit formula when calculating profit for one item is: profit = price – cost

Calculating profit for a higher quantity of items involves deducting direct costs, such as materials and labour and indirect costs (also known as overheads) from sales. Under normal accounting rules, sales and expenses are included in profit when they occur, not when they are actually paid so profit will include credit sales and purchases even when they are yet to be paid.

Here is an example. 

A business buys £3,000 of stock in January and agrees to pay for it in three months’ time. It sells the stock in the month in which it purchased it (January) for £5,000 cash. The profit for the month is £2,000. 

The fact that the stock wasn’t paid for immediately is not relevant when calculating profit. The profit that is calculated will derive from the ‘profit and loss’ account and will be calculated for a set period, usually a year.

It is important for a business to understand how much profit they’ve made to give it an idea as to whether the business is successful.

With so much money going in and out of a business, it is not always easy to see whether what a small business owner is doing is actually making money. By calculating profit, it helps give some clarity.

If a business is making a profit it can:

• expand and grow
• attract more investment
• employ more staff.

It is worth mentioning that profit is different to cash. Some things will affect the cash flow of the business, but won’t affect profit e.g. money taken out of the business for personal use. Likewise, some items will affect profit but will not affect cash such as provisions e.g. where a business makes an adjustment for a customer not paying.

Unfortunately personal expenses will not reduce profit nor will cash taken out of the business for personal use. So, reducing your profits to nil and paying no tax by drawing out all of your profits as cash won’t avoid a tax bill! 

For a sole trader, personal expenses will be called drawings and include cash taken out the business for personal expenditure, such as household bills and holidays. 

The purchase of capital items – e.g. fixed assets such as computer equipment and machinery – can be allowed as business costs if they are used in the business. However, because they are assets and are therefore expected to last a long time in the business, profits are reduced over a number of years by the cost and not all in one go.

The starting point for tax purposes is the profit that has been calculated from the profit and loss account. However, there are different rules with regards to what is allowable as an expense for accounts purposes and what is allowed for tax. Certain expenses are not allowed as expenses for tax purposes, such as fines and client entertaining. It is best to speak to a professional for help in this area.