9 Mar 2020
Making a profit is your primary target when running a company as it will ensure financial success and allow you to grow and take earnings.
Never just start a business and hope profits will come. Learn about profit measures and how to calculate them. Then work out how much profit you want to make, and plan how to achieve that by finding the right balance between sales, pricing and costs.
There are three main measures of profit, each measuring something different about your company’s performance.
Gross profit measures how much profit you generate from your direct costs.
Net profit tells you how much money you have made and can take home in earnings or reinvest in the business.
Operating profit is the profit your company makes before interest and taxes, and measures core performance and potential.
All businesses measure their gross profit and report it in their accounts.
It is the profit a company makes after deducting the costs associated with making and selling its products or services. Put another way, gross profit is the money you take minus what it cost you to directly generate those takings, also known as direct costs or cost of goods sold.
You therefore calculate it by subtracting direct costs from total sales over a certain period.
For example, if you sell sofas for £1,000 and you buy the furniture from a wholesaler at £600, your gross profit is £400 per item.
To work out your gross profit margin, divide gross profit by total takings, then times it 100 to get a percentage. In the above example, it would be 40%.
This margin shows how efficient a company is in using its resources - such as labour or supplies - to produce goods or services. The metric only considers costs that vary with the level of output, such as materials; sales staff commissions; credit card fees on purchases; and shipping. It also includes direct labour, such as hourly wages or those otherwise dependent on output levels.
The gross profit calculation does not include fixed costs - those that you must pay regardless of the level of output, such as rent, insurance, office supplies and salaries for employees not directly involved in production.
If you understand your gross profit margin, you can use it to calculate whether any extra costs involved in getting additional sales are worth the expense.
For example, to improve sales, you could try to attract more customers by offering discounts. But if you sell more goods, you may need to increase your costs to cope with the extra demand, so this will affect your net profit.
Rather than offer discounts, you could put your prices up if you think people would still buy the same amount. Even if it results in selling slightly fewer goods, that could still improve gross profit if it keeps takings the same but reduces costs and gives you more time to work on marketing, for example.
It can be useful to compare your gross profit margin with other companies in your sector. If your margin compares poorly to others, you might consider ways to reduce the costs of sales – for example, by using cheaper materials or direct labour, or renegotiating contracts with suppliers or shipping firms.
Net profit is the key indicator of a company’s performance because it shows how much of your sales are actual profit after factoring in all your operating costs – which include direct and indirect expenses – interest on any loans and taxes.
To calculate net profit, take your gross profit (sales minus direct costs) then subtract indirect costs, interest and taxes. Indirect costs are everything else that is a cost to your business including all the fixed expenses such as rent and insurance, as mentioned above.
Your net profit margin shows what proportion of your sales is actual profit. To calculate this, divide your net profit by your total takings and multiply by 100 to get a percentage.
If your net profit is low, you might try to improve sales or look for ways to improve efficiency throughout the business. For example, you could look to make savings in administration; renegotiating any loans; find a cheaper place to rent; or try to get discounts on office supplies.
You might also try to improve your tax planning, for example, by making sure you are claiming all business expenses and other allowances. Taking advice from an accountant can often help here.
Operating profit is a measure of the profit a company generates from its core business functions before interest and taxes. It also excludes any profits earned from the firm's non-core investments, such as partial investments in other businesses.
The difference between net profit and operating profit is that the latter excludes interest and taxes from the calculation, so operating profit is also known as earnings before interest and tax (EBIT).
Interest, tax and ancillary investments are often not fundamental to the company’s performance. Operating profit is, therefore, a measure of a company’s core efficiency and potential earnings.
Operating profit margin is often used to benchmark one company against others in its sector.
To calculate operating profit, subtract operating costs from gross profit. Operating costs are all the expenses associated with your business’s daily maintenance and administration – including direct and indirect costs but excluding major capital outlays.
To calculate operating profit margin, divide the operating profit by total sales and times it by 100 to get a percentage.
Many factors can affect operating profit, including pricing strategy, prices for raw materials, and labour costs. Because these items relate directly to managers’ daily decisions, operating profit gauges managerial flexibility and competency, particularly during tough economic periods.
Many companies try to reduce operating expenses to become more competitive, but you must do this with care as it could compromise the quality of operations. Finding the right balance can be difficult but can also yield good results.
Finding the right accounting software can make this task easier by helping you calculate all these profit measures and giving you an overview or dashboard.
However you find the balance, you need to be happy with all your company’s profit measures before attending to other parts of the business.