Do you get confused when people talk about gross profits, net profits, and profit margins? If so don’t worry – you are not alone. Of course they are terms that every accountant should understand, and many business people do understand them as well, but there a lot who don’t.
It is important to know what the terms mean though, as you will be able to use them to take decisions in your business. You don’t necessarily need to be able to work out the calculation – you can get your accountant to do that – but if you understand what the terms mean, you can use them to change the things that are not working, expand the things that are, and make more money.
Do you know, for example, what the gross profit is on your individual products or services? When you work that out you might find that the products or services that bring you in the most revenue – i.e. the ones you think are working well for you – are not actually making you much money. On the other hand you might discover that products that you don’t place much emphasis on are actually hugely profitable and, despite their comparatively low volume, make a significant impact on your bottom line.
What Is Gross Profit?
Gross profit is usually the first figure that you will work out. It is a fairly simple calculation that takes the amount of revenue that you make, and subtracts the costs of the goods or services.
Gross profit = revenue – cost of sales
Let’s look at two examples – a car servicing business and a clothes shop.
The car servicing business charges €300 for a service – this is the revenue part of the equation. The business pays a mechanic €80 for the time spent actually doing the service. They also buy oil, filters, coolant, and other items totalling €70. The “cost of sales” for this service is therefore €150. You can now put that into the equation:
Gross profit = €300 (revenue) – €150 (cost of sales)
So the gross profit is €150.
The clothes shop sells a dress for €100. The “cost of sales” part of the equation is the amount of money that the shop bought the dress for from the wholesaler or designer. In this example we will say they bought it from the designer for €60.
Gross profit = €100 (revenue) – €60 (cost of sales)
So the gross profit is €40.
What Is Net Profit?
Net profit takes into account all the other costs associated with running your business – your overheads – as well as the cost of the sale. Usually you work out your gross profit first, so the calculation is as follows:
Net profit = gross profit – overheads
Overheads include things like rent, rates, taxes, salaries, advertising costs, etc.
How You Should Use Each Figure
When you know your gross profit margin you will be able to analyse whether your prices are too low, or your direct costs are too high. With your net profit calculation you will get an overview of all your expenses compared to the revenue you are bringing in. You will then be able to decide on expenses you can cut, or revenue you can increase, in order to reach greater profitability.
If you would like help working out the gross profit and net profit margins in your business, or if you have any other query, contact Gilroy Gannon today.