Business activities serve many important functions. They create jobs, introduce new technology and contribute to community economic development. However, making a profit is literally the bottom line. Profit, or net income, is the last line on a firm's income statement and equals the amount the company keeps after expenses are subtracted from revenues. A business either earns a profit or it does not survive in the long run. This fact makes calculating annual profit a central concern for owners, investors and managers.
The income statement is a financial document a business must prepare that details how the firm's profit or loss for the year was calculated. Profit, or net income as it is usually listed, is the bottom line on the income statement. A simplified version of the profit is the amount remaining after all expenses and allowances are subtracted from gross revenues. Expenses include the direct cost of making or purchasing goods for sale, operating expenses such as selling, administrative and general expenditures and non-operating expenses such as depreciation, financing charges and taxes. When expenses exceed gross revenues, the bottom line will be negative and the business has a loss for the year.
Profit for the year is a key measure of a company's success. The annual profit is also a base figure for analyzing a firm's performance. For instance, it can be expressed as a percentage of sales or "profit margin" that can be used to compare the year's earnings with prior years or with the profit margins of other companies in the same industry.
Annual profit is also a valuable planning tool for managers. For instance, annual profit is used for projecting average annual profit in future years and the annual rate of return stakeholders can expect for the business or a specific project under consideration.
The profit for the year formula is actually a series of short calculations. Start with the firm's gross revenues from its business operations and deduct direct costs. For retailers, this is the cost of goods sold. For manufacturers, it is the cost of raw materials and direct labor. The result is gross income. Suppose the Super Widgets Company has gross revenues of $6 million annual sales and direct costs of $3.3 million. The gross income remaining equals $2.7 million.
The next step is to deduct operating expenses, which include selling, general and administrative costs such as rent, utilities, property taxes and advertising. For the year, Super Widgets had $1.7 million in operating expenses. Subtracting this amount from gross profit of $2.7 million leaves an operating income of $1 million.
Non-operating expenses not related to the business's operations come next and include interest paid, depreciation and miscellaneous amounts. At this point, any income from investments or profit from the sale of capital assets is added. Finally, federal, state and local income taxes are deducted. For Super Widgets, these expenditures come to $600,000, leaving net income of $400,000. This net income is the company's annual profit.
The average accounting rate of return is an estimate of the profit a firm is likely to realize from its future operations or for a new project. ARR is based on the company's past annual profit figures and projections of future costs and revenues. It is an example of how annual profits are useful for planning purposes.
To calculate ARR, begin by determining projected profits. The average annual profit formula is the sum of annual profits divided by the number of years. Suppose a firm projects annual profits of $400,000, $500,000 and $540,000 for three years. Adding these figures together and dividing by three gives an average annual profit of $480,000.
The average accounting return formula is the average annual profit divided by the initial investment, expressed as a percentage. If the company would invest $4 million in a project and projects $480,000 average annual profit, this works out to a 12% return. If this rate of return is better than that available from alternative investments, the firm will proceed with the project. Otherwise, it might look elsewhere for investment opportunities.