Making as many sales as possible is the goal of every business. Whichever service you offer to your customers, that is going to be what you’re aiming for. However, what really lies behind a successful business story is the profit generated from these sales. In this week’s blog, we will go one step further and look at two types of profit you would typically encounter, gross profit and net profit. What exactly does gross and net profit mean? What’s that all about?
Gross profit in business terms is the profit made once you deduce the costs the business has incurred for manufacturing the goods and/or providing the services. An easy way to grasp the meaning of it is through examples.
For example, Maggie sells homemade biscuits outside her house at 50 pence a biscuit. Now, if she sells a hundred of those, then she ends up with £50. Those £50 are her sales, but it’s not her profit. Maggie needs to spend £10 first for flour, eggs, and sugar. She reckons this will be enough to make a hundred biscuits all in all. This means that she gets a £40 profit. Those £40 are her gross profit.
Here are some other examples.
- If you are a retail business, the difference between the cost of buying stock and selling it is gross profit.
- Where your business is a food business, the gap between the cost of making a meal and selling it is gross profit.
- If your business is a training business, the difference between course fees and room hire and materials is gross profit.
- For a manufacturing business the product selling price minus the cost of making it is the gross profit.
For your information, you’ll find gross profit referred to as gross margin, which is merely a different name for the same thing. And the costs of buying sugar, lemons, stock, room hire, etc. from the examples above are cost of sales.
Now, net profit is the amount that your are left with after subtracting the additional expenses, interests, taxes and so on. For a better understanding, let’s analyse Serena’s example again.
Maggie, our biscuit seller above made a gross profit of £40. Life would be wonderful for Maggie if she could keep all of that for herself. However, business life is not as comfortable as that and there are certain costs Maggie had over and above the costs of flour, eggs, and sugar.
There are the costs of printing flyers, paying rent on her stand, and wages to her friend Serena. She worked on the stall when Maggie needed a break. The cost of all this is £30, which leaves Maggie with a net profit of £10.
There are also several different ways to refer to net profit – just like there are synonyms or different terminology used for gross profit. This is very common in the accounting world. But let’s clear the confusion once and for all.
Net profit can also be called operating profit, EBIT or PBIT. If we convert those acronyms to words, here’s how things stand:
- EBIT = Earnings Before Interest and Tax,
- PBIT = Profit Before Interest and Tax.
In case you are wondering, earnings is just another word for profit in our International Universe.
Gross profit and break even
Let’s make a comparison like this. Think of gross profit like sawdust. A single sale doesn’t mean much – just a bit of gross profit i.e. sawdust. But make more and you can see the difference. Because with every sale you make that pile of sawdust gets bigger and bigger. It builds up. Your business target is for your gross profit to cover all your support costs.
For Maggie, her support costs of £30 were for printing flyers, renting her stand, and wages to her friend Serena. Additional examples of support costs include business utilities, printing and stationery, insurance, repairs, etc. You get the picture.
As you sell things, your gross profit builds up. The first milestone are your support costs. When gross profit hits that first checkpoint, you have covered all your support costs. Drumroll, please. You’ve hit break even.
So, break even is actually the state when you do not have any profit, yet all your expenses are covered. And you are not losing anything. In a way you are at 0, and from there you build forward.
Going back to our example with biscuit seller Maggie enables us to look at this through a numbers lens. She has a gross profit of 40 pence per biscuit. Her support costs are £30. If Maggie sells 75 biscuits, she breaks even. When she sells biscuit number 76, that extra biscuit gives her 40 pence and biscuit 77 leaves her with a total of 80 pence of net profit.
I’ll give you a bit more jargon just in case you find these words elsewhere and you’re not sure what they mean. So, support costs are also called overheads, running costs, expenditure, operating costs, or expenses.
What to do to be more profitable
If you want your business to be more than a hobby, then you need to make profit. It’s the only way you’ll survive and thrive. For that reason, you need to make sure you pay close attention to the numbers. Sales are amazing and do, in fact, show how your business is moving. They show you if your customers are happy with your services and goods i.e. if they like what you have to offer. However, that is just one aspect. What is really important is the final number you are left with after everything has been covered.
So, let’s say Maggie wanted to make more profit. There are several things she could change. For example, she could charge more than 50 pence per biscuit, spend less on flour, eggs and sugar, or cut down on wages and advertising.
It is easier, but not easy, to control and influence the cost of sales, such as flour, room hire, or materials, just to name a few. It is slightly more difficult to control support costs like insurance, salaries and wages, and business rent.
Gross profit and net profit insights make adapting your business model easier
Numbers, like gross and net profit, form your business decisions, but they don’t always dictate them. For example, cheaper flour might mean making poorer quality biscuits, so her customers would buy less and complain. In a worst-case scenario, bankruptcy could be looming.
If Maggie increases the selling price beyond 50 pence, she may end up selling fewer biscuits but makes a bigger total gross profit. In contrast, if she reduces the selling price below 50 pence, this might mean selling more biscuits. If the numbers work out, she could end up making more gross profit.
Once we get our heads around gross and net profit, there’s quite a lot that we can do to improve profit-making. Pricing strategies, decisions on outsourcing, dropping products, evaluating business opportunities, and sacking clients, are just a few examples of the application of gross and net profit.
If you want your business to carry on, learn to understand and keep an eye on your gross and profit. Learn how to use this knowledge to create successful selling strategies that will bring your business to a higher level rather than suffer and lose money.
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