Making a profit is a primary goal for most businesses when they’re starting out. Profit is also an important metric that’s used to inform business decisions. But what kind of profit should you be tracking?
This article explores three main types of profit and how they can support you as you make strategic decisions about business growth.
What Is Profit?
Profit is the money you have left in your business bank account after all your expenses have been paid. It takes the amount of money your business earns through the sale of its products or services, then subtracts the amount spent on making or delivering those products or services and keeping the business running, including paying salaries, utility bills, and rent.
It can be important for business leaders to not just measure profit figures but also make sure those figures are relevant and meaningful to their operations.
It can be easy to confuse profit with other financial measures, such as revenue and cash. Revenue is the amount of money your business earns through selling its products or services. It differs from profit because it does not take into account (or deduct) expenses. Cash is the amount of money available in your business bank account at any given time.
A business needs to make a profit and generate cash. Making a profit can enable you to reinvest for growth, such as through expansion or new product lines, as well as to withstand fluctuations in demand and unforeseen downturns. Generating cash ensures there’s enough money in the bank each month to pay your expenses.
Different Types of Profit
There are three main types of profit: gross profit, operating profit, and net profit. Gross profit focuses on direct profitability of goods, while operating profit measures how effectively a business is spending money to make products and maintain day-to-day operations. Net profit is a cumulative metric that looks at how much money a business has left after all revenues have been added and expenses have been deducted. All three are commonly represented as a percentage known as the margin. Each can show different aspects of success – or failure – of a financial period and can be worth exploring in greater detail.
Gross profit represents the profit a company makes after deducting the direct costs (typically, raw materials and labor) associated with producing and selling its goods or services. On the income statement, which is a core financial statement, these costs will likely be labeled “cost of goods sold,” or COGS. Calculating gross profit allows you to ensure your direct costs of selling goods or services don’t exceed your revenue. This can help you identify the impact of any cost increases and can inform decisions related to ways of increasing profit margins, such as switching suppliers or changing a product’s pricing strategy.
- Gross profit in practice: Business owners and decision-makers use gross profit to measure the profitability of specific products, storefronts, or overall production. It can help them see where margins are slipping to inform changes in marketing and inventory strategies. For example, if a business notices its gross profits are plummeting for goods sold to third-party retail distributors but marked-up direct customer sales are bringing in higher profits, the business can consider switching its marketing strategies to focus on direct sales and minimize – or eliminate – its B2B sales tactics. This same approach can be applied to other aspects of the business, such as reviewing low- versus high-margin goods or store performance to help decision-makers decide whether to drop less-profitable operations to focus on strategies that minimize costs and increase revenue.
Operating profit starts with your total gross profit, then deducts your operating costs, which 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 can be variable.
- Operating profit in practice: Analysts commonly scrutinize operating profit when exploring cost-cutting opportunities. Since operating expenses are typically easier to control than COGS (which can be influenced by external factors, like supplier prices), they present a target-rich environment for potential savings. A rising operating profit indicates robust operational performance. This is a key metric for investors, creditors, and lenders looking to assess creditworthiness and ensure regular day-to-day business activities have healthy cash flow and profits.
Net profit is the final indicator of profitability and is found at the bottom of the income statement – hence, its nickname, “the bottom line.” It takes into account all revenue and expenses, including the cost of servicing debt, income, and losses from business investments. These non-operating factors are subtracted from operating profit to measure the overall profit or loss for a financial period.
- Net profit in practice: Net profit represents the true earnings of a business after all expenses are accounted for. It’s the money that can be paid out to owners or reinvested in business opportunities, such as new product development, real estate, or equipment. Stakeholders, especially of public companies, can also use net profit to gauge a company’s financial health and earning capability.
How Often Should Profit Be Measured?
The frequency of measuring profit can vary based on a business’ specific conditions. Businesses with predictable demand and fixed costs, such as service businesses, are more likely to have fairly static gross, operating, and net profit. This means a monthly check-in and quarterly deep dive may suffice.
For other businesses, especially those with razor-thin margins, fluctuating demand, or varying stock levels, profitability can be checked in detail at least once a month, if not weekly or even daily. This regular flow of profitability analysis can inform short-term decisions, such as when to boost marketing spending or whether it makes sense to stockpile resources when the market is in your favor.
In any case, it can be important for business leaders to not just measure profit figures but also make sure those figures are relevant and meaningful to their operations.
Determining the viability of a product, a business endeavor, or even an entire company often revolves around profitability, but there’s no one-size-fits-all yardstick for all businesses. At the end of the day, it’s essential for most businesses to bring in more money than they spend. The three different types of profit – gross, operating, and net – can offer valuable insights into the direct profitability of a business’ products (gross), day-to-day operations (operating), and the overall financial standing of the company (net). With this information, decision-makers can see exactly where their money is going, find areas ripe for increasing margins, and develop a deeper understanding of their own successes.
A version of this article was originally published on November 10, 2022.
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