Businesses use terms such as gross profit, operating profit and net profit or loss to describe their operations. The operating profit, which is the gross profit minus operating expenses, tells you how much profit your business made before taxes and certain other items, across all of its product categories and geographies. When you want to know the profit for one or two product items over a period of time, an average profit calculation becomes useful. So, what is the average profit's definition and why should you care?
Average Profit Definition
The average profit definition is the total profit divided by the output or the sum of the profits during each period divided by the number of periods. An average profit calculation formula might look like average revenue – average cost = average profits.
For example, if a company makes $100, $200 and $300 in the first three years of its business, but loses $200 in the fourth, then the profit formula for the business would read: ($100 + $200 + $300 - $200) ÷ by 4. The total average profit ends up being $100.
Importance of Knowing Average Profits
Businesses have to make choices, often in difficult times. Managers can use an average profit formula for their business to see if a product is profitable enough, if a division is making enough money per year or if a product is making money in a particular city or country, for example.
The average profit can be used to gauge how a company is doing through the bad times and the good. For example, a media company that had higher average profits than its industry peers in 2019 — when journalism layoffs were at an all-time for the first time since the recession — is probably a well-managed company. If a particular brand is failing to make an average profit, then senior management can decide to discontinue it, or perhaps put in new managers to try to turn the business around.
Types Of Average Profit Calculations
You can calculate the average profit of the whole business or any part of it using a profit calculation formula. For example, you can calculate the average profit of the operating divisions to gauge how the respective managers are performing. You can also calculate the average profit margin of a product or a business, which is the average profit divided by the average selling price or average revenue. If you are an investor, you could calculate the average profit of your trades during a month, either in a particular stock or across the portfolio, to see if a change in trading strategy is warranted.
Considerations Regarding Average Profits
The actual profit may not be the same as the actual average profit over prior periods, or the average profit estimate for the current period. As it turns out, the average profit formula for a business might not actually be an accurate predictor at all.
For example, Tumblr was purchased by Yahoo! for $1.1 billion in 2013. A valuation that high means Yahoo! was anticipating major profits. Unfortunately, the company didn't perform anywhere near as well financially as expected. Verizon (which owns Yahoo!) later unloaded the company for less than $3 million. It was a loss because of poor predictions.