One of the first indicators of business success or failure is the ability to make a profit. While making a profit isn’t a total arbiter of success, making a loss over a long period of time is almost always a sign your business is going to fail.
Some profitable businesses manage to fail quite spectacularly, but we’ll talk about that more in another post.
When talking about profit it is important to distinguish between 3 different terms:
- Gross Profit
- Net Operating Profit (sometimes referred to as Net Profit before tax)
- Net Profit after Tax
All appear on the Profit & Loss Statement of your business (sometimes called a Statement of Financial Performance) and each can be influenced in different ways to make your business more successful.
What is Gross Profit?
Gross profit is the amount of money your business makes from sales after the costs of making and selling your products are deducted.
Gross profit is the surplus amount before you pay for operating costs, payroll, tax and overheads.
Gross Profit is considered the most important indicator of the success of your business and should be monitored in detail.
How to Calculate Gross Profit
To calculate gross profit, take your total sales and subtract the cost of making or selling your product.
Total sales - cost of goods/services sold = gross profit
For example, your business sells $12,000 worth of products, and it costs you $8,000 to make those products. This would leave a gross profit of $4,000.
$12,000 total sales - $8,000 cost of making the product = $4,000 gross profit
Gross profit can be influenced by selling prices and purchasing prices as well as productivity and sales volumes.
Net Operating Profit
Net Operating Profit (or Loss) is what you have after deducting your operating costs such as marketing, property, vehicle, communication, and office expenses as well as depreciation.
It is the profit from your business operations before tax and non-operating income and expenses.
Net Profit or Net Loss?
Net profit is the total amount of profit your business makes, after all expenses including tax and adjustments such as non-deductible expenses, are taken off the Net Operating Profit.
Unsurprisingly, net loss is the opposite of net profit. Net loss occurs when expenses exceed the income or total revenue produced for a given period of time.
How to Calculate Net Profit Margin
A business's net profit margin shows what percentage of sales is actual profit. Net profit margin factors in the business's cost of goods sold, operating costs and taxes.
To calculate your net profit margin, divide your sales revenue by your net income.
Net income ÷ total sales = net profit margin
The result is your net profit margin. You can multiply this number by 100 to get a percentage.
For example, say your business makes $12,000 in sales, it cost you $8,000 to make your products, and you spent another $2,000 on operating costs (such as overheads and taxes).
Total sales - (cost of goods sold + operating costs) = net income
$12,000 - ($8,000 + $2,000) = $2,000
Net income ÷ sales = net profit margin
$2,000 ÷ $12,000 = 0.1667
0.1667 × 100 = 16.67%
In this example, your business would have a net profit margin of 16%. Therefore, 16% of your total sales revenue is profit.
All Tidied up in Your Profit & Loss Statement
At its simplest, a profit and loss statement shows how much your business has invoiced to customers and how much you have spent to produce those sales over a specified time —usually a month, quarter or year. It can be detailed showing every line item or summarised.
One of the most important pieces of information in a Profit & Loss Statement is the trends over time.
Is your sales increasing or decreasing?
Is your gross profit increasing or decreasing at the same rate as sales?
Are your operating expenses consistent each year or are their significant variation in one or several expense items?
Any unexpected changes require further investigation. Trends of declining sales or profits need urgent action.
If you would like to know more about how your business is performing call us today on 0800 236 446 for a no obligation FREE Business Health Check.
Let Engine Room Chartered Accountants take care of the numbers for you so you can get back to running your business.