Gross Profit, Operating Profit, Net Profit – What does it all mean?
Revenue – Expenses = Profit
Seems quite simple but delving deeper there are many forms of profitability which all tell a different story of how a business is operating.
What does profit tell you?
Profit is the money a business makes after paying all expenses. Whether it is a small school fete to a multinational company, the primary goal of any business is to generate surplus. Primarily one of the main KPI (Key performance indicators) of any business is based on profitability. This profit is usually distributed out to owners / shareholders or reinvested back into the business.
Unbeknownst to all, there are various forms of profit, each providing more information about the performance of a business. Analysing this shows whether business is performing well compared to competitors as well as where savings / improvements can be made.
These various forms take the name of:
- Gross Profit
- Operating Profit
What is Gross Profit?
Revenue – COGS (Cost of Goods Sold) = Gross Profit
Gross profit simply shows how much money you make against the cost of the product. It is an imperative measure as it is the starting point towards achieving a healthy net profit. If your gross profit is negative, then there are already issues that needs to be addressed.
You can take the Gross Profit one step further by calculating the Gross Profit Margin % (Gross Profit / Revenue). Simply, this shows how much margin you are making on each sale. It is a great indicator to compare your performance to similar industries to show whether your pricing or cost of your product / service is aligned.
Gross profit and Gross Profit % are affected by many factors. A business can have high / low gross profit / gross profit % because:
- It has differentiated its product and can charge high prices (Apple).
- It has economies of scale and can purchase raw materials / products at lower costs (Woolworths).
Gross profit should be used in tandem with Operating Profit to measure the business performance.
What is Operating Profit?
Gross Profit - Operating Expenses = Operating Profit
Operating profit is the Gross profit (above) less any other expenses except for interest and taxes. This includes expenses like wages, depreciation, admin, maintenance and utilities. It is significant indicator of the business performance as it includes all sales and expenses necessary to keep the business running. In simple terms, it is the result of the core business.
Operating profit and Gross profit are intertwined but not directly linked. A business can have a positive Gross Profit but a negative Operating profit (loss). This is a result of considerable operating expenses. An example is shown below:
Gross Profit: $1,000
Wages $500
Marketing: $500
Other: $100
Net Profit (Loss): ($100)
The business made a positive gross profit, but spending too much on other aspects of the business caused it to generate a loss.
Operating profit is a measure of business management and competency, particularly during tough economic times as the expenses incurred by the business are directly related to day to day decisions by the owner / management.
What can be done to increase Profit?
Some actions can be done to increase a business’s profitability without the obvious method of making more sales. All these needs to be reviewed carefully as it may impact relationships with external stakeholders.
- Increase / review prices
- Don’t offer discounts
- Review your expenses for unnecessary items
- Negotiate discounts from suppliers
- Review inventory or slow-moving items
Regardless of the size of the business, reviewing and understanding these profit metrics can provide significant insights in how the business operates. It can provide an indicator of operating efficiency and product margins, the first step in developing the correct strategies to grow the business.
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