In this video, I will be revealing the most important accounting equation. Watch now!
Boy am I excited. I have been waiting to do this video. There are a lot of cool equations in accounting. But the equation we are going to talk about today is so important, that everything in accounting revolves around this one equation. I know you are on the edge of your seat. But do not worry. We are going to start off the video, by laying out the equation. I call this the profit equation.
Revenue – Costs = Profit
Now you might be saying. “Really? That is so simple. Everyone already knows this equation.” I would respond to you, “No they do not.” If people really understood what this equation is saying, we would not have half the problems we have in this world. This equation means something really significant. If you are an accountant, it is your responsibility to understand the nuance of this equation and communicate that to your organization. So in this video we are going to dive deep into what this equation is really saying.
Defining the Equation
Let us look at the equation again. Income statements basically follow this pattern. There is a lot more detail on the income statement, but I have simplified it down to its most basic form so we can have this conversation.
First, I want to define the terms.
- Revenue means income or sales
- Costs means purchases made by the business
- Profit is the result of comparing Revenue and Costs
Now in accrual accounting, revenue and costs do not always equal the value of cash going in or out of the business. But just for the sake of understanding this visual: revenue is making money, and cost is spending money.
The Point of the Profit Equation
Second, we need to understand the point of this. The point of accounting is to look at an organization and determine its impact on the world. Whether the business is big or small, we are trying to understand if the organization is creating value. People do not stop to think about this, but this is an incredibly amazing process.
Here is how revenue is determined. Every individual on the planet has a certain amount of resources. This might be physical like land or equipment. It could also be intangible like knowledge or talent. Each person arranges those resources in their life to produce a result. So a doctor arranges their life to produce medical procedures. A construction worker arranges their life to create buildings. An HR employee arranges their life to perform HR tasks for a company. So each of these people are creating a certain level of value. They create a benefit for society and all these people get paid according to the value they create.
In an organization, you are combining all these individuals in some organized goal. This social network creates a certain level of value for society. They sell a product. And you can keep building this process upward. So you can look at the revenue created as a region, or a country, or the world.
Then you have to add the cost. Any of these organizations is spending money to operate. Each individual in the organization is buying things to achieve their impact. At the overall level, you can add all those purchases up to arrive at your organization’s cost.
Once we have the cost, we can look at profit. If costs are less than revenue, you produce a profit. If costs are greater than revenue, you produce a loss. What profit is really saying is how much value is created. You spent a certain level of resources and you organized them in a way to create more value than they were originally worth. You brought in revenue that cost you a lower amount.
The reverse is if you generate less revenue than your costs. This creates what we call a loss instead of profit. In that situation, you are actually destroying value. You are taking resources, and turning them into a product or service that people are willing to pay a lower price, then the resources were worth originally.
My point is that this equation takes a very complex system of interactions, and expresses that in a very simple equation. That is amazing if you think about it. For example, imagine you have three companies that build computers. A computer company is a very complex organization, with hundreds of employees each doing different tasks and making purchases. This equation lets us roll all that complexity into one simple number: profit. And we can compare the profit of these three different companies.
Imagine the three companies have profits of 100, 50, and -100. Two are profitable and one is generating a loss. These companies could be drastically different sizes, so to simplify things, let’s imagine they are roughly the same size. Looking at these numbers tells you who is generating value, and who is destroying value. Obviously, the first company has figured out a way to build computers that is more effective than the other two companies. The company making a loss is actually destroying value. Every computer they build actually costs them more money than people are willing to pay for it.
The more you dive into this equation, the more complicated it becomes. A loss is not necessarily bad. This equation is always defined by a specific period of time. For instance, an income statement might describe profit generated during a year. But depending on what you are looking at, a year might not be a long enough period. You might generate a loss during one year, but over a five year period, you could generate a huge profit. So you have to be careful. Sometimes it makes sense to make a big investment to generate profit down the line. A simple example of this is college. You spend money on college when you are younger to increase your earning potential when you are older.
Then let us take non-profit organizations. Non-profits by definition do not make a profit. What is going on? Non-profits exist because they generate value for the overall community. They are usually solving a social problem that will not show up on any one person’s financial statement. For instance, a government is non-profit and they will build roads. Those roads benefit everyone in the community. So the people are really generating the profit, not the government. The government shows a zero profit, because they have spent the money they were allocated to solve the social problem.
We have really broken this equation down. Organizations are generating value or losing value, and your financial statements are built around understanding this equation.
The Big Picture
Now I want to look at the bigger picture. There is a larger process that this equation fits in.
- Organizations are engaged in activities.
- Financial statements describe those activities.
- Use metrics to make decisions.
What you need to realize is that accountants are the people who perform step number two. You cannot go from step 1 to step 3 without accountants. They are enabling this whole process that is driving your business.
What I am trying to say is that this equation is power. Are you making a loss or a profit? This allows you to look at your organization and find out where you are effective, and where you are not. When you focus on those things you are effective at, you will generate even more value.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.