Small business owners should have a basic understanding of the financial statements that are prepared for their companies. It isn’t necessary to be an expert, but you must at least know the fundamental accounting rules and principles.
You should also familiarize yourself with some of the concepts that your accountant uses. One of these is the difference between gross profit, net profit, and operating profit.
Entrepreneurs keep a close track of their companies’ sales. They know their revenue figures on a daily, weekly, and monthly basis. They also maintain a careful watch on their cash position. Most business owners would know the exact amount they have in their bank account on any given day.
However, the level of knowledge that business owners have about their firms’ profits isn’t as precise.
The picture becomes even hazier when you consider that your financial statements provide you with three different profit figures – gross profit, operating profit, and net profit.
What do these numbers convey?
What’s the difference between gross profit vs. net profit vs. operating profit?
Is one more important than the other?
What’s the relationship between them?
Let’s find out.
What is gross profit?
Gross profit is the amount that remains after you deduct the cost of goods sold from your revenue.
Here’s the gross profit formula:
Gross profit = Revenue – the cost of goods sold
You should remember that the revenue figure indicates net sales. Net sales are calculated by deducting discounts from the sales amount. You also need to reduce the sales amount if any goods have been returned by customers.
To calculate your gross profit, you need to know the cost of goods sold. These are the costs that are directly incurred for producing the goods that have been sold. Some of these costs are:
- The cost of the raw materials that have been used to manufacture goods.
- The wages paid to workers who are directly employed in the production process.
- The cost of finished goods that are purchased for resale.
- Packaging and shipping costs.
How do you know which costs are to be considered for calculating the cost of goods sold? Remember that the critical issue is whether the cost can be directly attributable to the production of goods. Indirect costs are usually not to be taken into account.
A higher gross profit provides your company with more money to meet its other expenses. While gross profit is an important measure of profitability, there are other profitability measures that you must also consider.
You should also know how to calculate the gross profit rate for your company. This is the percentage of sales that is in excess of the cost of goods sold. If your sales are, say $100,000, and the cost of goods sold is $60,000, your gross profit rate is 40%:
$100,000 – $60,000 = $40,000
($40,000 X 100) / $100,000 = 40%
Once you carry out this calculation, you can use the gross profit rate to estimate the gross profit you would make with an increase in sales.
What is operating profit?
Your operating profit tells you the amount that your company is making from its business operations.
Here’s the operating profit formula:
Operating profit = Revenue – cost of goods sold – operating expenses – depreciation – amortization
Which expenses are considered when calculating the operating profit? All costs that are incurred for your business activities must be taken into account. Here are some of these costs:
- The rent that you pay for your office premises.
- Your utility costs.
- Advertising and marketing costs.
- Depreciation and amortization.**
** Depreciation is charged on tangible assets (like plant and machinery), and amortization is charged on intangible assets (like franchise agreement costs).
Remember that when calculating operating profit, the interest cost incurred on loans is not to be considered. Neither is the tax that your company pays.
Consequently, operating profit is also referred to as earnings before interest and tax.
What is net profit?
Net profit is the final profit figure for your company. It is the amount you have left after accounting for all expenses.
Here’s the net profit formula:
Net profit = Total revenues – total expenses
When you are analyzing your company’s gross profit vs net profit, the critical issue that you have to remember is that gross profit takes only the cost of goods sold into account. The net profit, on the other hand, is the profit after all expenses have been considered. This is the essential difference between gross profit vs net profit.
Don’t assume that net profit and the cash that your business generates is the same thing. In fact, the two are quite different.
Your net profit is arrived at after considering your revenue and expenses for a specific period. The revenue could include credit sales.
Similarly, you may not have paid the supplier for some of the expenses that are accounted for. Both these transactions will affect your net profit, but will not have an impact on your cash balance.
Business owners should know that an increase in net profit doesn’t necessarily mean that your cash balance will go up.
Let’s understand this point with the help of an example.
Diego runs a small auto repair shop. At the end of the financial year, he raises an invoice on a customer for $1,500. The payment is made by the customer to Diego after two weeks. In this transaction, the sale took place before the year-end, but the cash was received in the new financial year. To put it another way, Diego made a credit sale in YEAR 1 and received the money due to him in YEAR 2.
In YEAR 1, the revenue of Diego’s company would increase by $1,500, but there would be no effect on the cash balance. Remember that the cash was received in YEAR 2. In other words, in YEAR 1, the net profit would be higher without a corresponding increase in the cash balance.
However, there are ways to convert profit into cash. One of the ways to do this is to focus on collecting the money that is due to you from the credit sales that you have made to customers.
There’s another measure that you can take to increase your net profit.
You could lower the interest cost that you pay on borrowed funds. Camino Financial offers small business loans at reasonable rates of interest. You may discover that taking a loan from us could lower the amount you pay towards interest.
Gross profit vs net profit vs operating profit: the main differences
When a reference is made to a firm’s “profit,” how can you tell whether it’s about the gross profit, the net profit, or the operating profit?
Is there any way to determine the difference between the gross profit vs net profit? Or for that matter, how can you make the distinction between operating profit and net profit?
Bear in mind that the amount alone won’t help you to differentiate between gross profit vs net profit. You have to find out how the sum has been calculated.
Here’s a table that compares how the three types of profit are computed.
|Gross profit||Operating profit||Net profit|
|How it’s computed||Revenue – COGS*||Gross profit – operating expenses**||Total revenues – total expenses|
|Which expenses are considered for calculating this type of profit?||Raw material costs, direct labor, shipping costs, cost of goods purchased for resale||All the costs considered for calculating gross profit plus costs like rent, expenses on utilities, advertising costs, depreciation, and amortization||All expenses incurred by the firm|
|Why it’s used||It reveals your operational efficiency||It tells you about the financial performance of your core business activity***||Also known as net income, this is a measure of your firm’s overall profitability|
* COGS is the cost of goods sold
** Operating expenses include depreciation and amortization
*** Operating profit doesn’t include the gain from activities that aren’t related to your main business
Gross profit vs net profit vs operating profit in real life
Let’s use an example to get a better idea of gross profit vs net profit. While we’re doing this, we’ll also calculate the operating profit.
This is the income statement of Cathedral Bakers for the year, 2018.
|Cathedral Bakers’ income statement for 2018|
|Amount in $|
|Cost of goods sold||30,000|
|Employee costs (not included in the cost of goods sold)||4,000|
|Rent and utilities||2,000|
|Total operating expenses (4,000 + 2,000 + 1,000)||7,000|
|Operating profit (Gross profit – operating expenses)||13,000|
|Net profit (13,000 – 1,000 – 1,000)||11,000|
What does Cathedral Bakers’ Income Statement for 2018 tell you about its gross profit vs net profit?
You can see that the firm’s gross profit is $20,000.
However, after deducting all the costs that it has incurred this falls to a net profit of $11,000.
Do you know all of your profits?
Studying your gross profit vs net profit numbers can provide you with the information you need to improve your business performance.
The gross profit amount tells you about your operational efficiency. The net profit is the final profit that your business has made for the relevant accounting period.
Business owners should monitor these amounts carefully to achieve success.
If you want to know how to become more profitable, read: