Understanding profits and profit margins is essential for business owners and business decision makers to achieve their ultimate goal: earning the money they need to succeed and grow their business.
The same goes for a small business owner starting a web design business in his basement or a high profile CEO running a multi-billion global company.
To be successful, everyone must make enough money to make a profit and earn enough to ensure the prosperity of the business, for themselves and their families, employees, shareholders and community.
This is exactly where the calculation of profit comes into play.
What is a benefit?
In a nutshell, profit is the amount of money a business, big or small, makes relative to the money it spends to run the business.
Often known as net income, profit is the money left over after each of these business expenses has been deducted over a specific period of time (called the “accounting period”). For example, most publicly traded companies measure their earnings on a quarterly basis, publishing earnings reports that compare their profits and losses.
Profits are often used as a yardstick for measuring a company’s performance. If profit margins are high, it usually shows that management is making the right decisions, that the company is making or selling the right products in the right way, and that the company’s vision for the future is correct and should be used. as a plan for moving forward.
Similarly, low or no profits, or worse, financial losses, usually means that the company could be facing significant problems, including poor management, low demand or disinterest in the product or service it is selling. offers, and inadequate sales and marketing efforts.
There is no doubt that profit is the ultimate goal of anyone in business. If you’re not making money, your business may very well have a short lifespan, so getting profits right and measuring them right is a big deal in business.
Are profits and income the same?
Profit and revenue are similar in that they both measure the money coming into a business, but that’s where the similarity ends.
Let’s take a look at both profit and revenue and see how they differ – and why this distinction is important:
Profit. Again, profit is the financial metric used to measure a company’s performance. It is the money left over after each business expense has been recorded over a specific period.
Revenue. Revenue is the amount of money a business takes in as part of its business.
While revenue represents all of a company’s revenue, profit is the important number in a financial statement – it shows what’s left after a company pays all of its bills.
This is why revenue cannot be used to accurately compare financial performance.
Yes, recording revenue is important because you want to know how much revenue your business generates directly from your products or services. But revenue doesn’t tell the story that profit does – you can have significant revenue, but your business can still show a loss if the money you have coming out of your business exceeds the money you’ve poured into the company.
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Different types of benefits
There are different forms of profit that every business decision maker should know and know how to measure:
- Gross profit. Gross profit is a category of a company’s income statement that records total revenue less the cost of products or services sold by a company. In accounting jargon, gross profit is a company’s profit before operating expenses, interest payments, and taxes are included.
- Operating profit. Another key category of a business’s income statement, operating profit is the amount of money left over after deducting expenses used to run a business from gross business profit. Normally, expenses come from three lines of business – sales, general expenses and administrative expenses.
- net profit. Also known as net income, net profit is the amount of cash left over after operating expenses have been subtracted from a company’s total income. Operating expenses that must be deducted include interest, taxes, and preferred stock payments. Basically, net profit means the money a business earns after paying business fees and expenses.
- Economic profit. Economic profit is the difference between the revenue received by a business and the opportunity cost of doing business. Businesses opt for different business strategies all the time with multiple possible outcomes. In this regard, economic profit is the amount of money a firm earns after choosing one business strategy over another business strategy that the firm could have chosen – but did not.
What is profit margin?
A profit margin is a number representing a company’s profitability, expressed as a percentage on the company’s income statement. The higher the percentage, the more money the company earns, once all expenses have been paid.
There are two types of profit margins – gross profit margin and net profit margin.
How to Calculate Gross Profit Margin
Accounting specialists use profit margin as a barometer of company pricing strategies. If the calculation results in a low gross profit margin, company decision makers may need to adjust prices for products or services upwards.
Gross profit margin is calculated by deducting cost of goods sold from net sales. Then divide the remaining number into net sales to calculate the percentage, or ratio, representing gross profit margin.
How to Calculate Net Profit Margin
Net Profit Margin calculates exactly what it suggests – a company’s total profitability, across all of its products and services. Like any profit margin, it is expressed as a percentage.
A robust net profit margin suggests that the business is on the right track and growing over a specific period (usually quarterly) in a healthy way. A low net profit margin is usually an indicator of problems that can include poor management decisions, low demand for products and services, high costs, and ultimately low sales and revenue.
Net profit margin is calculated by dividing a company’s net income by total sales, then multiplying the result by 100. A company’s net profit margin calculation includes all of a company’s costs and revenues.
Overall, the correct net margin calculation is as follows:
Profit Margin = Net Revenue / Net Sales (Revenue)
Profit Margin Calculation Examples
Here is an example of calculating the gross profit margin:
Remember that gross profit margin is gross profit/total revenue multiplied by 100.
- A company’s revenue is $100,000.
- The cost of the company’s products or services is $80,000
- The company’s gross profit is $20,000 ($100,000 minus $80,000).
The total gross profit margin is $20,000/$100,000 x 100 = 20%
Along with the total net profit margin, a business will add, for example, $10,000 for the rest of the business expenses. Adding this figure into the calculation will give a net profit margin of 10%.
$10,000 (additional expenses)/$100,000 x 100 = 10%
Make the right choices
Understanding how profit impacts a business and how it is calculated is a financial priority for business decision makers. Getting it right could be the difference between a business that is on the path to success and one with a bleak, short-term financial future.