Gross profit and net profit are important financial metrics in any small business, and knowing the difference between them is vital in understanding the performance of your business.
Here’s what you need to know….
What is gross profit?
Quite simply, your business makes a gross profit when your sales revenue (i.e. units sold x sales price) exceeds your direct expenses – these are the total costs related to manufacturing and selling your products and/or service (also referred to as the cost of goods sold (COGS) or cost of sales, and includes everything that’s directly connected to creating and selling your product and/or service).
What type of costs fall under the COGS?
Anything that’s directly related to the cost of creating and selling your product and/or service. For example, labour that’s used to create that product and/or service; materials; shipping; supply; equipment and repairs etc. will all fall under COGS.
What type of costs aren’t included under the COGS?
Any business costs that aren’t directly related to the production and delivery of your product and/or service. This may include rent, insurances and salaries.
How do I calculate gross profit?
The calculation for gross profit is straightforward, as long as you’ve got all of your COGS recorded accurately.
Revenue – COGS = Gross Profit
What is a gross profit margin and how do I calculate it?
Gross profit margin is a measure of profitability that shows the percentage of revenue that exceeds the COGS.
It is calculated as a percentage, and is worked out like this:
Gross Profit / (Total Revenue x 100) = Gross Profit Margin
What is a good gross profit margin?
Your gross profit margin will depend on the type of product you’re selling…if you’re selling low volume goods your gross profit margin will generally need to be higher than if you’re selling high volume goods.
A higher margin is usually preferred, as this would indicate a company is selling inventory for a higher profit. Generally speaking, the greater your gross profit margin, the lower the volume of sales required – a gross profit margin of 50-70% would be considered healthy (the gross profit margin provides a general indication of a company’s profitability).
Why is it important to know your gross profit?
Your gross profit is a great indicator of how economically you’re using labour and how much it’s costing you to make your goods and/or deliver your service. It gives you valuable insight into your pricing policy and can help you identify opportunities to reduce some of the costs you encounter, and gives you a solid idea of the viability of your business long-term.
If the cost of delivering any aspect of your product and/or service increases, your gross profit will decrease, meaning you’ve got less money to spend on running the business.
Essentially, gross profit is used to estimate a company’s profitability.
What is net profit?
While gross profit gives you clarity on how much it’s costing to deliver your goods and/or service, net profit gives you clarity on how much money you’re making as a business, when factoring in every expense the business incurs (i.e. total expenses). The costs that aren’t directly related to the production and sale of goods or services are operating expenses and this is included in the total expenses figure.
By subtracting operating costs from your gross profit you can calculate your operating profit, and by further subtracting your interest and taxes from you operating profit, you can calculate your net profit, i.e. net profit is how much money you have left after all costs and expenses have been accounted for.
What costs should be included when calculating net profit?
COGS, along with everything that goes out: including rent or mortgage, insurances, taxes, depreciation, overheads, salaries, bank fees and legal bills.
What shouldn’t be included when calculating net profit?
Nothing. Every outgoing(expense) the business has, must be included in the net profit calculation.
How do I calculate net profit?
Net profit is calculated by subtracting your total expenses (COGS + operating expenses) from your total revenue:
Total Revenue – Total Expenses = Net Profit
What is a net profit margin, how do I calculate it?
The net profit margin measures how much profit is generated as a percentage of revenue. You can work out your net profit margin by dividing your net profit by your total revenue.
Net Profit / Total Revenue = Net Profit Margin
What is a good net profit margin?
The answer to this question will differ, based on which industry you operate in – generally, & 20% is a good net profit margin.
Why is it important to know your net profit?
Your net profit margin ultimately shows how successful the company is and is a key factor in determining performance. It shows a company’s performance over the course of a year and is the figure the company can then use to make decisions around future investment(s) and company growth..
By comparing the gross and net profit, you can get valuable insights into where money is being spent in the ‘operational’ side of the business, and work towards operating more efficiently (if there’s an opportunity to do so).
What if I have a negative net profit?
It depends on a few factors, for example: the age of the business, market conditions and trends etc. Some new businesses may project to make a loss for the first few years while, as the business gets established – and that’s fine, so long as it’s part of the plan. If you encounter unforeseen circumstances that damage your profits, however, it’s smart to take stock and devise a plan to address the challenges you’ve identified.
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