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How does a business measure its profit and the return on an investment?

The concept and calculation of gross profit and net profit; the calculation and interpretation of the gross profit margin, the net profit margin, and the average rate of return.

A focused answer to Edexcel GCSE Business 2.4.1, covering the calculation of gross profit and net profit, the gross and net profit margins, and the average rate of return, with worked examples.

Generated by Claude Opus 4.89 min answer

Reviewed by: AI editorial process; not yet individually human-reviewed

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  1. What this dot point is asking
  2. Gross profit and net profit
  3. Profit margins
  4. The average rate of return
  5. Try this

What this dot point is asking

Edexcel wants you to calculate and interpret gross profit and net profit, the gross and net profit margins, and the average rate of return on an investment. These are the core financial calculations of Theme 2.

Gross profit and net profit

The two measures answer different questions. Gross profit shows how much a business makes after paying the direct cost of its goods (the cost of sales), before any other expenses. Net profit goes further, taking off all the other running costs (overheads such as rent, wages and bills), to show what the business actually keeps. A business can have a healthy gross profit but a small net profit if its overheads are high, so both figures matter.

Profit margins

Margins turn the profit figures into percentages, which makes comparison easy. A gross profit margin of 40%40\% means the business keeps 4040 pence of gross profit from every pound of sales. Margins let a business compare its performance over time (is the margin rising or falling?) and against competitors (is it more or less profitable than rivals?). A higher margin is better; a falling margin warns that costs are rising or prices are being squeezed. The gap between the gross and net margins shows how much the overheads eat into profit.

The average rate of return

The ARR helps a business decide whether to make an investment. It works in two steps: first find the average annual profit (total profit from the investment divided by the number of years), then express that as a percentage of the cost. A higher ARR means a better return. The business can compare the ARR with the return from an alternative investment, or with simply leaving the money in the bank earning interest; if the ARR is lower than the bank's interest rate, the investment may not be worth the risk.

Try this

Q1. A business has revenue of 80,00080{,}000 and cost of sales of 50,00050{,}000. Calculate its gross profit. [1 mark]

  • Cue. 80,000−50,000=30,00080{,}000 - 50{,}000 = 30{,}000.

Q2. A machine costs 20,00020{,}000 and earns total profit of 30,00030{,}000 over 55 years. Calculate the average rate of return. [3 marks]

  • Cue. Average annual profit =30,000÷5=6,000= 30{,}000 \div 5 = 6{,}000; ARR =6,00020,000×100=30%= \dfrac{6{,}000}{20{,}000} \times 100 = 30\%.

Exam-style practice questions

Practice questions written in the style of Pearson Edexcel exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Edexcel 20204 marksA business has revenue of 200,000200{,}000, cost of sales of 120,000120{,}000 and other operating expenses of 50,00050{,}000. Calculate its gross profit and its net profit. (Paper 2, Section A)
Show worked answer →

A 4-mark calculate question: two calculations, two marks each, method rewarded.

Gross profit == revenue −- cost of sales =200,000−120,000=80,000= 200{,}000 - 120{,}000 = 80{,}000.

Net profit == gross profit −- other operating expenses =80,000−50,000=30,000= 80{,}000 - 50{,}000 = 30{,}000.

Full marks need both figures, with the net profit correctly using the gross profit. A common error is to subtract the expenses from revenue directly without finding gross profit first; while it gives the same net figure here, the question asks for both, so the gross profit must be shown.

Edexcel 20224 marksA business is considering a machine costing 40,00040{,}000 that is expected to earn total profit of 60,00060{,}000 over 55 years. Calculate the average rate of return. (Paper 2, Section A)
Show worked answer →

A 4-mark calculate question for the average rate of return (ARR), method rewarded.

Step 1, average annual profit == total profit ÷\div number of years =60,000÷5=12,000= 60{,}000 \div 5 = 12{,}000 per year.

Step 2, ARR =average annual profitcost of investment×100=12,00040,000×100=30%= \dfrac{\text{average annual profit}}{\text{cost of investment}} \times 100 = \dfrac{12{,}000}{40{,}000} \times 100 = 30\%.

The ARR is 30%30\%. Full marks need the average annual profit step and the percentage. A common error is to divide the total profit by the cost without first finding the average annual profit, or to forget to multiply by 100100. An ARR of 30%30\% can be compared with the return from other investments or from leaving the money in the bank.

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