The discrepancy relates to the various legal formats of businesses. Those entities that are tax pass-through entities do not pay income taxes at the business level, but pay those taxes at the investor level; thus the confusion with the definition of profit. In some business formats, it refers to the net income after taxes whereas in the pass-through entities, it refers to the net income before taxes are paid at the investor level. For a better understanding of pass-through entities, please read: Types of Business Entities.
Profit is often misused and misunderstood by even some of your more sophisticated businessmen. The problem is that the term is generic and to use it correctly it should be qualified. The following are the various different qualifiers:
- Net – refers to the bottom line earnings from a business operation after taxes in the traditional corporate format. In the tax pass-through formats, it refers to the bottom line prior to taxes which are paid at the investor (partners, members, beneficiaries etc.) level.
- Operating (EBIT) – identifies the amount earned before payment of taxes, interest, and/or other significant costs.
- Gross – this refers to sales less cost of the goods sold or services rendered.
- Direct – refers to sales less those costs directly related to the production of the item sold or the services rendered.
- Indirect – refers to sales less direct and indirect costs.
In general, net profit is used to determine the overall success of the business operation. For the common person; the greater the net profit, the greater the success of the business. This is not necessarily the case in all operations. The key are the goals of the business organization. Some organizations exist to serve society such as non-profit charitable institutions. Profit does not measure their success. Others are large corporations where profit is essential, but so is the long term continuity of business. In some operations, increased profits come at a cost of staff or the quality of their products or services. There is give and take in fulfilling all these various goals. In essence, profit is not the true measurement of success; it is merely one of the indicators of overall success.
In addition, profit is often sited based on an accounting cycle of some duration. A more astute businessman will desire to understand the trend of profit over several periods than to place absolute reliance on the current profit. In addition, several uncontrollable forces (economic conditions, change in demographics, weather, interest rates etc.) can greatly impact the profit calculation and therefore a reader of information should take into consideration these outside forces in evaluating profit.
For the purposes of the reader, profit refers to the financial return net of all costs and expenses to the owners of the business. It is best to use one of the qualifiers when using the term to be more definitive of the different meanings for the term ‘Profit’. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.