In this article, we explore the three main types of profit you can measure and how they can support you in making strategic decisions for business growth.
- What is profit, where it derives and why it's important
- The different types of profit (gross, net and operating)
- Full breakdown of gross profit
- Full breakdown of operating profit
- Full breakdown of net profit
- How often should a business measure profit
What is profit?
Profit is the leftover money in your business account after paying all expenses. It's derived from selling products or services and deducting production, delivery, and operational costs.
Profit differs from revenue and cash. Revenue refers to sales income without expense reduction. Cash signifies the existing money in your business account.
A profitable and cash-generating business is essential. Profit-making enables growth reinvestment and adaptability to market shifts, while cash generation helps cover monthly expenses.
Different types of profit
There are three main measures of profit. These are gross profit, operating profit and net profit.
- Gross profit: total revenue minus the cost of goods sold (COGS).
- Operating profit: gross profit minus operating expenses, like rent, wages and utilities.
- Net profit: operating profit minus taxes and interest. Your take home, bottom line profit.
Gross profit and operating profit measure how effectively your business is spending money to make its products and maintain day-to-day operations. Net profit looks at how much money your business has left after all expenses have been deducted. All three are commonly represented as a percentage, known as the margin.
Let's take a closer look at each of the different types of profit:
Gross profit
Gross profit is the income from the sales of your products, minus the direct costs involved in making them, which are also called cost of goods sold (COGS). These include labour and raw materials. Gross profit enables you to check that your costs aren’t becoming excessive and to identify the impact of cost increases, such as whether you need to switch suppliers or change your pricing structure.
James Greenwell, owner of beauty and wellness manufacturing business On-Group, measures gross profit for each of his five business units every month to understand which are profitable and which are breaking even or making a small loss. Based on this data, he can decide where and how to adjust his strategy.
An example of this in action is when one of his units suffered a downturn in sales as a result of the COVID-19 pandemic.
"Pre-pandemic, we were ticking over about £35,000 per month from [sales to] bricks-and-mortar beauty salons," says Greenwell. "When the pandemic hit, that dropped to below £10,000 per month, when beauty salons were forced to close."
As a response, Greenwell decided to switch strategy from selling products to beauty salons to selling them directly to consumers. The move saw their customer base jump from 4,000 to 40,000 customers in two years, with sales rising nearly fourfold from £300,000 to £1.2 million in that time.
Operating profit
Operating profit takes your total gross profit and deducts your operating costs from it. These are the costs associated with the day-to-day running of your business, such as rent, heating, lighting and insurance. Some of these costs are fixed each month and some are variable. Operating profit is also sometimes referred to as earnings before interest, tax, depreciation and amortisation (EBIT or EBITDA).
“Reviewing your operating profit regularly will help with decision-making, such as whether or not you can afford to make investments or need to make cutbacks,” says John Edwards, CEO of the Institute of Financial Accountants. “It may also be used as an indication of your cash flow health and your ability to borrow."
Profitability reflects company success, but for daily operations, growth pursuits, and meeting financial commitments, a positive cash flow is vital.
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Net profit
Net profit is the final indicator of profitability. It takes into account the cost of debt to a business, income received from business investments, and taxes. This figure is then deducted from or added to operating profit. Net profit shows you what money you have left at year-end after all expenses have been paid and therefore what money you have available to re-invest.
“Net profit is what keeps the company going,” says Greenwell.
"In a good year I'm looking at between 7 and 9% net profit in the business and, if I achieve that, then I normally allocate 2% to new business models," he adds. "That can be anything from product development to buying bricks-and-mortar, launching new brands or new websites."
An example of this was Greenwell's decision to launch a new product that he believed was an opportunity to be first-to-market. By looking at net profits, he knew he could allocate up to £100,000 to its development.
How often should profit be measured?
How often you measure profits depends on your business. For services, most costs are fixed, making gross, operating and net profit fairly static, explains Edwards. This means that a monthly check-in and quarterly deep-dive should suffice.
For other businesses, these measures will vary against factors such as fluctuations in market prices, variance in stock levels, and demand. In this case, you should think about measuring profits weekly, or even daily, as the data should inform short-term decisions such as stockpiling resources when the market is in your favour, or boosting marketing spending.
“Where businesses often fall is that they prioritise the measurement of figures but not the relevance of those figures to the business,” says Edwards. .
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