Profit and Profitability are often matters of concern in the running of any organization. This is mainly because the main purpose of doing business is to make profits. Companies majorly streamline all of their activities to ensure that they are earning a great profit margin when they are transacting in business (Samad 2015: p.173). This is because they are trying to make sure they earn more profits in their business activities. Business operates in multiple models, and thus they have different ways of operating to ensure that they increase their profitability. What one needs to know first is that a business may decide to increase its profitability by first of all reducing its operating costs. They may decide to come up with their own facility to supply themselves with raw materials rather than buying from suppliers which will greatly reduce the cost of production (Margaretha & Supartika 2016: p.135). Additionally, companies may decide to increase their profitability by trying to increase the number of sales they make in a single selling. This may majorly come from the business making efforts to advertise the business to the general public so as to ensure that there are more people who are willing to buy the product and to make an improvement in the sales the company is making. All of these are very effective models of making profits, and they all operate in different ways with each business choosing its most appropriate business model which can fit their organization. This is because some businesses are nonprofits while others are a for-profit business. As such, their parameters for measuring profitability may vary from company to company. There are various tools that are used effectively in measuring the profitability of a business.
Methods of Measuring Profitability
Payback Period Method
The payback period method is used to test for the period it will take a business to recover the fully invested amount in the business. This method of calculating profit first of all factors in the level of capital that has been invested in the business. For starters, a company may obtain profit from various sources which are at the company's disposal. A company may obtain capital from fundraising while it can also obtain profits through a loan from a bank which will be very helpful in helping the company to grow to a great extent. The company then makes a forecast of when they expect to get their first profit. This is done through developing a predictive cash flow system which is used in measuring the level of profit the company will be making per year (Ehrhardt and Brigham 2016: p.35). For instance, the company may estimate the level of success it will have over the set period it has in the future five years and then decide how much profit it might have over that said period of five years and then calculate the time it will take for them to get back the capital that was invested into the business at first. This model of calculating profit bears numerous advantages and disadvantages alike. This method of evaluating profitability also tests for the appropriate of a project and whether it should be put into action or it should be avoided. This works in such a way that, if at all a project takes two years to achieve the capital and then there is another project that takes three years then the two years one will be taken and put into action.
This technique for testing for profit operates in the following manner. If say a project requires $10000, and it is expected to generate a total of $2500 per year which implies that it should be able to restore the initial capital after a period of 4 years. Then it ought to be calculated in the following manner.
Pay Back Period (PBP) = Initial Investment/Annual, Cash Inflow
Or P = C/A1
Where P = Pay Back Period;
S = Initial Investment or the cost of the capital project; and
A1 = Annual Cash Inflow
Or, P = 10,000/2,500 = 4
Therefore, the PBP of this project is 4 years.
This method of measuring for profitability is main;ly used in measuring the appropriateness of a project and how effective it can be to the company. One of the main attributes of this model is that it gives the employer the ability to test for the ability of the project to fulfill all of the set targets. For instance, it tests for the ability of the project to reach the capital within the set target. If at all the project has the ability to restore the amount within the set period then it is taken back. However, if it goes beyond the set target time, then the projected is usually forfeited since it is not able to meet the set requirements. Also, it may be forfeited due to the fact that it does not get to meet the specific requirements that the company has set within the set time limits which might enable the company to accomplish all of its goals.
This method of measuring profitability bears numerous merits and demerits when it comes to achieving company goals. For starters, this mode of testing for profitability is very easy when it comes to calculating profitability which makes it very easy to apply (Adusumilli, Davis and Fromme 2016: p.64). This method of calculating profitability enables a company to look at the various risks attached to the various [projects that it plans to undertake over its whole period of operation. This enables a company to avoid the many pitfalls that it could get into while it is trying to attain its set goals. The method also places a great emphasis on the close returns than on the distant returns which enables the company o try and attain its goals faster than waiting for distant profits for a time that may be very unpredictable and therefore offer numerous challenges to the company (Margaretha & Supartika 2016: p.135). The other advantage that this technique has is that it takes much lesser time to calculate profit than it takes for other techniques. For starters, this technique is very simple which makes it very possible for the company to make lots of resources within a short period of time. The technique can also get utilized in a fast-changing industry because it enables a business to key in all of the dangers or changes that may be related to a project. The technique is also helpful in that it enables business organizations to make good decisions when it does not aim at making an early return on the business or the project they are planning to set up.
The technique bears a very misguided way of measuring profitability. For starters, it assumes that project that takes too long to repay the capital investment is much lesser advantageous to those that6 take a longer period. This assumption is a misguided one because this is not always a true standard for all businesses across the world. Apparently, the technique also fails to take to account the cash flows that mainly occur after the set period has been reached. Apparently, a company may be very profitable within the proposed period which will enable it even to pay its starting capital before it has reached the aid target. However, dynamics in the market may change and cause the companies to make huge losses which may even lead to the company closing down due to a great level of losses. On the other hand, the company may fail to meet the set target but become profitable after the stated payback period. It also neglects the time value of money which is majorly affected by changing inflation trends across the world which may greatly endanger the sustainable and growth of a company (Aviza, Turskis and Kaklauskas 2015: p.830). Apparently, over time it is possible for money to lose or gain value significantly which may make a company either profitable or unprofitable. The technique also ignores the fact that there is a lot of revenue which can be collected for selling debris which may arise from the project that a company may be undertaking. The main reason why a business would shy away from this method of testing for profitability is that it does not factor in all of the cash flows that can come into a business. Rather, it only considers the cash flows that would come in during the estimated and targeted Payback period. It also not dependable considering the fact that markets are always changing due to changes in the business world. This may imply that there will be a great change in the level of profitability in the company which is a factor the PBP method does not factor in.
Average Annual Rate of Return (AARR)
The method of measuring is majorly based on the annual returns that a company brings. It majorly tests for the factor of returns on investment and thus seeks to find an average in this method and make the average that the business can generate over the entire period when it is in operation. It is measured by finding the percentage of the investment in the project that the returns have brought back to the company over the entire year.
AARR = Average Annual Return/Average Investment in the Project x 100
For example, if the average annual return of a project is $60,000 while the initial cost of the project is $600,000, the annual rate of return will be as under:
AARR= 60,000/600,000 x 100
Thus, the AARR is 10%.
The whole process of calculating the AARR involves, first of all, subtracting the initial investment from the total gross income during the whole period when the project has been in operation. The process then moves to a stage whereby the net profit gets divided across all the years so as to find the average income that the company has made per year. The process then moves into the stage where the average annual income gets divided with the initial investment. This finally gives out a result of the return on investment. If at all the management finds out that the AARR is higher than the expected return then it is assumed that it is a good project which implies that it gets undertaken. On the other hand, if at all the management finds fault in the project whereby the project does not meet the targeted returns then it is forfeited since it is generally perceived not to be a profitable business.
This method of calculating the profitability of business has numerous merits and demerits. One of the major merits of the technique is that it is very easy to calculate and also understand (Aviza, Turskis and Kaklauskas 2015: p.830). For starters, it has a very simple procedure which takes a very easy progression. This majorly saves the company a huge amount of time which can enable it to act on other activities in the business. The wh0ole process is majorly based on accounting data which is usually readily available to the company. At any pointy in any given organization that plans to progress and grow, it usually maintains a high level of data keeping methods to ensure that it is able to keep track of its progress as a company. This process does not majorly rely on data that the company may not have (Leung 2014: p.278). Rather, it uses readily available data to come up with the answer to whether a company is making a profit or not. The AARR method differs greatly from the PBP method due to the fact that it considers all the activities that bring in cash into the company. As aforementioned, the PBP does not put into account other cash flows which a company may have after completing a project. The AARR method takes into account all of the cash flows associated with the company and hence it can prompt a high level of profitability for the company.
The AARR also bears numerous demerits due to a number of factors. One of the main factors that discredit it as an appropriate method of measuring profitability i the fact that it does not put into consideration the fact that money changes value over time. Apparently, factor concerning inflation and also money related policies alter the value of money from time to time (Srikanth, et al. 2017: p.183)....
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