This is the sixth post in a series of articles on real-life facts that you need to know for the GMAT. Here’s the full list:
Economics: Profit and Non-profits
Revenue, Costs, and Profit
This basic nexus of ideas could be relevant on Critical Reasoning, on Reading Comprehension, on any math problem, or even in Integrated Reasoning. Moreover, if you are planning on going to business school, getting an MBA, and pursuing the life of a manager in corporate America, you absolutely have to know these basic Economic 101 terms.
1. Revenue — this is all the money that comes into any particular company. For many companies, this would be composed primarily of money from sales. Other revenue sources might include investments of some kind.
2. Costs — this is tricky. The word “cost” in the singular means the price an individual or business must pay to obtain a good or service. In the plural, the word has a very different connotation. A business’ costs are all the expenses, all the outgoing money. The words “expenses” and “expenditures” mean substantially the same thing. Typically, a business’ costs would include payroll (i.e. wages of employees), insurance, taxes, possibly some investment in materials or resources, possibly rent on a space, and possibly R&D (research & development).
3. Profit — for any successful business, incoming money is more than outgoing money, and profit is the difference between these. In other words:
Profit = Revenue – Costs
If this number, the profit, equals a negative number — that is, if the outgoing expenses are larger than the money the business is taking in, then that business is operating at a loss. That’s not good. Sometimes, it may be that a particular division of a company operates at a loss for a while, and the larger company, which is making a profit, chooses to support this unprofitable division for a time, perhaps allowing it to develop to the point of turning a profit on its own. Sometimes, also, companies take strategic losses — for example, expensive investments that are likely to pay off big in the future. Yes, that’s a gamble of a sort, but then again, everything in the business world is a kind of gamble!
Any company is an ongoing thing that changes and develops through time. Typically, revenues and costs and profits are specified either for a year or for some other fixed time period (per quarter, per month, etc.)
Gross vs. per-item
This is a distinction that can be particularly tricky in a variety of problem. A problem (RC, CR, math, or IR) might give some information in terms of gross revenue, gross costs, or gross profits — that is, the total dollar amount for that quantity across the whole company —- and revenue or cost or profit per item or per sale. Many very predictable errors when students confuse gross quantities with per-item quantities.
For clarity, consider this real life example. Suppose Company X has $30,000 in total costs each year, and makes $40,000 in total revenue each year, and thus clears $10,000 in profit each year. Now, suppose, in a typical year, this company sells 200 items. This means — the cost per item is 30000/200 = $150, the revenue per item (presumably the price of the item) is 40000/200 = $200, and the profit per item is $50. So far, so good.
That was an extremely simple example. For a typical company, some costs (perhaps rent and wages) are fixed at some gross level, and others (perhaps materials used) depend on the number of units produced. Problem #2 in this post draws this distinction.
Notice, also, the “per item” quantities are fractions, and the value of a fraction changes either if the numerator changes or if the denominator changes. Consider that same Company X — suppose in the next year, it makes $8,000 in profits, selling a total of 100 items. Now, its profit per item is 8000/100 = $80. Its profit per item went up, but its gross profit went down. That’s bad. A company always wants its gross profit to go up, even if profit per item declines.
The purpose of a business, the fundamental reason any business exists, is to make money, to make a profit. Other institutions, serving basic human needs, exist primarily to serve those needs, and making a profit is not nearly as important. An institution is called a nonprofit organization if it formally falls into this latter category.
Nonprofit organizations typically include most schools & educational institutions, most hospitals and health institutions, scientific research facilities, museums & symphony halls & many artistic venues, public broadcasting, churches & synagogues & religious institutions, and charitable organizations of all sorts. Pretty much, any group that could ask you for a donation is a nonprofit. Businesses don’t ask for donations: instead, they try to sell you something! Some nonprofits, such as those serving the underprivileged, may run almost entirely on volunteers and thus have a budget of only a few hundred dollars a month, while others, such as large foundations or large laboratories or major universities, may control tens of billions of dollars.
Non-profits have very different tax code —- 501(c) status, a much more lenient tax-code — than for-profit businesses have: for example, nonprofits pay no income tax. Sometimes an organization will try to claim nonprofit status for the tax benefits. The IRS is particularly strict about which organizations qualify for the special benefits of nonprofit status: claiming nonprofit status involves a rigorous application process to the IRS, and several criteria must be met before the IRS will grant the benefits of nonprofit status to a particular organization.
For any non-profit, on average the profit will be zero, so on average, the gross revenue will equal the gross costs.
All this information is crucially important to understand, not only for a variety of GMAT questions, but also for your post-MBA life in general. If you have any thoughts or any questions, please let us know in the comments section.