Profit Comparison Calculation Definition and Meaning
Definition of profit comparison calculation
The profit comparison calculation serves to compare different investment alternatives by comparing their average profit.
The attributable costs are therefore deducted from the attributable income of the investment property. This results in the attributable profit, which forms the basis for comparison. The option that can expect the highest average profit should then be selected.
Area of application of the profit comparison calculation
A similar form of profit comparison is the cost comparison. There the costs are compared. However, it is criticized that, for example, it is not taken into account that compared machines can produce different quality.
This is exactly where the profit comparison calculation comes into play. If compared machines produce different levels of quality, this difference in quality also leads to different revenues. Profit comparison is therefore used when comparing objects that:
- Have different capacities
- Produce different quality
This ensures that not only costs are taken into account. Nevertheless, the advantages of a static method, in particular a simple calculation, can be used.
How do you do a profit comparison calculation?
The profit comparison calculation consists of three simple steps:
- Calculate revenues
2. Calculate profit
3. Compare the profits of the options
We will now go through these three steps in sequence and then have a simple example of the profit comparison calculation for you.
In order to be able to compare the expected profits of two investment options, you first need to know how many units can be sold at what price. If you multiply the number of items by the sales price, you get the total of the sales. All costs are now deducted from these sales revenues and so the profit remains.
The costs that need to fixed costs , as well as variable costs are considered. The variable costs include, for example, the electricity that a machine consumes to produce the assumed number of items.
When calculating, you should make sure that the net amounts are always used for all comparison objects and especially for the sales price and costs . The result of the calculation is then the profit per investment option. You compare the results and choose the option that has the highest profit.
Sample calculation and formula for the profit comparison calculation
A simple example of a profit comparison calculation looks like this: A company is faced with the decision to buy a simple machine for the production of commodities. The following 2 options are available:
- Option 1 is a machine that produces slightly poorer quality. Therefore, the selling price is set lower, but the costs are also lower.
- Option 2 is a machine that can produce slightly better quality products, which is why the sales revenue per piece is higher than option 1.
Calculation of option 1: 1000 pieces of € 10 each can be sold, the proceeds are therefore € 10,000, while total costs of € 5,000 are incurred (variable costs + fixed costs), leaving a profit of € 5,000.
Calculation option 2: 1000 pieces of € 12 each can be sold, the proceeds are thus € 12,000, while total costs of € 8,000 arise (variable costs + fixed costs). Thus, option 2 offers an expected profit of € 4,000
It turns out that the machine of option 1 allows a higher profit to be expected and is therefore advantageous. Apart from this simple calculation, further considerations could now be made. One starting point would be to determine whether customers are willing to pay perhaps 15 euros per piece for the quality that machine 2 can produce. Then the result of the calculation would look different again.
Types of investment objects
Typically, investment objects are compared that have different characteristics. Examples of this are varied, such as:
- Electricity consumption of compared machines
- Quality of the manufactured products
- Useful life of the objects
- Cost per piece
- Realizable revenues
That is why it is important to include the different features in the profit comparison calculation. The example described above only gives a simple insight into the simple method of profit comparison calculation. If one of the machines had a longer service life, that should also be included in the calculation. This ensures that the profit is calculated over the entire service life of the respective machine and not only compared statically for the first year, for example.
If, in the example described above, the machine, which at first glance appears to be inferior, could be used for a few years longer than the other option, the ranking could be changed again. It is therefore important that all influencing factors are taken into account when comparing different investment options. This is the only way you can be sure that you are determining a well-founded comparison value.
Comparison to cost comparison calculation
Cost comparison and profit comparison are both static methods . The main difference is that in the profit comparison calculation, as described, the focus is on the revenues. The attributable costs are nevertheless also taken into account. The profit comparison calculation is therefore definitely superior to the cost comparison calculation.
However, there are also investments for which a cost comparison calculation can be sufficient. For example, when it comes to which car to buy, there is no revenue side to consider. Thus, when choosing the method, it always depends on the upcoming investment decision.
Tip: Ideally, a cost comparison calculation is carried out first and this is then expanded to include a profit comparison calculation.
Advantages of the profit comparison calculation
The profit comparison calculation is very easy to carry out as a static method . Depending on the investment decision, it also has advantages over the cost comparison calculation:
With less data, a well-founded basis for decision-making can be created in the profit comparison calculation, although the calculation can be carried out quickly and easily using Excel. The profit comparison calculation is, so to speak, the next stage in the cost comparison calculation. This also includes the fact that products can be manufactured in different quality and thus also different sales revenues can result.
Disadvantages and problem areas in the profit comparison calculation
While the advantages of the profit comparison calculation are obvious, a closer look reveals certain weaknesses of this approach. In every company there are investment objects for which it becomes difficult to allocate revenues to this object in a very specific way. So mapping is one of the biggest challenges. But the fact that the calculation is partly based on assumptions is also a disadvantage. The sales proceeds can only be estimated. Which price can ultimately really be enforced on the market has a significant impact on profit and is often not clearly foreseeable at the time of the comparison.
It can thus be said that the profit comparison calculation is justified by the advantages mentioned. However, it should not be viewed in isolation as there are also obvious limitations and problem areas. A further consideration and comprehensive considerations before the investment decision are therefore absolutely necessary in addition to the profit comparison calculation.