Although the two terms tend to be used interchangeably, profit and profitability are not the same. Both can be used as accounting metrics in analyzing the financial success of a company, but there are distinct differences between the two. To adequately determine whether a company is financially sound or poised for growth, investors must first understand what differentiates a company’s profit from its profitability.
Definition of Profit
Profit is an absolute number determined by the amount of income or revenue above and beyond the costs or expenses a company incurs. It is calculated as total revenue minus total expenses and appears on a company's income statement. No matter the size or scope of the business or the industry in which it operates, a company's objective is always to make a profit.
Definition of Profitability
Profitability is closely related to profit – but with one key difference. While profit is an absolute amount, profitability is a relative one. It is the metric used to determine the scope of a company's profit in relation to the size of the business. Profitability is a measurement of efficiency – and ultimately its success or failure. Profitability can further be defined as the ability of a business to produce a return on an investment based on its resources in comparison with an alternative investment. Although a company can realize a profit, this does not necessarily mean that the company is profitable.
To determine the worth of an investment in a company, investors cannot rely on a profit calculation alone. Instead, an analysis of a company’s profitability is necessary to understand if the company is efficiently utilizing its resources and its capital.
If a company is deemed to have a profit but is unprofitable, there are a number of tools that can be used to increase profitability and overall company growth. A company can be quickly bogged down with failing projects, which directly leads to sunk costs. To reduce the occurrence of project failures, companies can explore a profitability index to determine whether a project is worth pursuing. This metric provides company management with insight into costs versus benefits of a project, and it is calculated by dividing the present value of future cash flows by a project's initial investment.
A company can also increase profitability through the theory of marginal returns. One of the first steps a company takes to increase profitability is to boost sales, which requires an increase in production. Marginal return, also known as marginal product, is a theory that states that the addition of workers up to a certain point increases the use of capital in an efficient way; exceeding that number of workers leads to diminishing returns and ultimately less profitability. In order to be profitable, it is necessary for a company to apply this theory to its specific business and production needs to experience growth in an efficient, cost-effective manner.