Small business owners often struggle with basic accounting terms. Television programs like Shark Tank often demonstrate this when contestants on the show are asked what their gross profit is, and they provide the net profit.
As a small business owner, it is important to know the difference between these two vital statistics as this can help you clearly distinguish opportunities and threats to your business and help you refine operations to make your business more profitable and successful.
So what is the difference between gross profit and net profit and how can you use those figures?
Gross Profit Margin
Gross profit is calculated by taking the total revenue of the company and dividing that by the cost to directly produce the goods or service sold (otherwise known as the cost of goods sold). The calculation of gross profit margin is, therefore:
Gross profit margin = (revenue - cost of goods) / revenue
For example, if you had revenue of $100,000 in a year and it cost you $30,000 to produce those goods, then the gross profit would be 70%.
Generally speaking, the better the gross profit, the better the health of the company. However, it is not a precise indication and companies with a healthy gross profit might have a poor net profit.
Net Profit Margin
This is considered to be the most accurate measure of your company’s profitability. It reveals the percentage revenue your company makes per dollar of sales. Net profit is the gross profit, as calculated above, minus the operational expenses and any other expenses (i.e. taxes and interest paid on debt).
The formula is expressed as below:
Net profit margin = (revenue - cost of goods - operating expenses - other expenses - interest - taxes) / revenue
This figure helps you to ascertain the financial health of your business. For instance, a low net profit margin, compared to gross profit margin will indicate that other costs are out of control. Therefore, you should look at ways to curtail certain costs, like rent, interest or operating costs to increase profitability.
While some believe that more sales will often lead to better profits, it is not always the case and is harder to achieve. On the other hand, having your business find ways to cut costs, is much easier and often leads to better results. The more competitive the market, the more imperative it is to look for ways to cut costs rather than just trying to increase sales.
How to Use the Gross Profit to Improve Your Business
While the gross profit margin is generally poor at displaying the true health of your business; it can help you decide if servicing your product is viable. High profit margins are very good, but it is all dependent on your market. For instance, bargain basement stores will have very low profit margins whereas the telecoms sector tends to have high gross margin profits.
Knowing what the average gross profit is across your sector is a key piece of information. Online websites detail lots of averages and using these can be a useful guide to determine how successful your business is compared to your competitors. You can also see if you have room to bring down costs (to attract new customers) or if you need to look for ways to produce your goods more cheaply.
If you do have lower gross profit margins than is acceptable within your industry, there might be many reasons. For instance:
• You might have too many defects which push up the cost per unit.
• Your staff might not be trained in the efficient way to produce goods or deliver services.
• Your equipment might be slow and outdated.
• Your materials might be costly.
Of course, in some niches, this might be expected. For example, organic farmers are more likely to have lower gross profit margins than non-organic because they tend to have less produce per acre and higher rejection levels.
Also, some businesses, like large national or multinational organizations, can afford to have a lower gross profit margin because they sell to so many customers on a daily basis. An example of this would be Walmart.
Therefore, use your judgement and only compare your gross margin with a like-for-like business.
How to Use the Net Profit to Improve Your Business
Your net profit can be an important metric when looking for ways to improve your business. Operating costs are often those that cannot be directly related to the production of your business. These include investment costs, customer service, lease or rent, etc.
Therefore, reducing these sizeable costs can be a good way to improve your business’ overall profitability. Many businesses across the world are always looking for ways to cut costs by reducing staff or moving premises.
One such example was the proposal from HSBC to move its global headquarters away from London to another country. Countries suggested included Canada, the US and Hong Kong. The principle reason for this proposed move was the bank levy that was introduced by the UK government in 2010.
Alternatively, you might think that cutting staff costs could be a better option for increasing your profitability. Dropbox famously did this to reduce the employee benefits package that was estimated to be about $25,000 per year, per person, or $38 million annually. Part of their cuts included cancelling its free shuttle in San Francisco, gym washing service and limiting staff dinner time perks.
These measures are proposed to improve the bottom line of the businesses not by selling more or reducing the costs to deliver its service, but limiting its operating costs. Here are some other ideas on how your business could save on similar costs that decrease your net profit margin:
• Renegotiate leases or move premises.
• Renegotiate loans or look for more favourable lenders.
• Cut back on unnecessary, lavish investments.
• Reduce staff overtime.
• Reorganize the staff structure.
By making these changes, you can ensure that you have a much healthier business model and produce better profit margins.
There is a significant difference between gross and net profit margins. Each can tell you something different about your business, its financial health and where improvements can be made. Therefore, by getting to grips with your business’ statistics, you can find a solution to make your business more successful and prosperous.
Do you need help determining your gross and net profit? Speak to a member of the Ragain Financial Team; we’re here to help.
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