Most business owners think they understand profits, margins and how much they’re actually making. The reality is that many don’t. How much is your business really making, and what should you do with it?
Cynics say that profit or loss is an accountant’s opinion about the business, that only cash is real. You need cash to run the business, to pay salaries and buy stock, but if you make losses instead of profits, you are likely to run out of cash.
Profitability is a serious issue; it pays to understand the principles and terms like gross and net profit. Do you keep track of profits or do you wait for the year-end results from your accountant, and hope for the best?
Gross profit explained
In simple terms, gross profit is the income from sales minus the amounts you pay to buy or manufacture the goods you sell. Gross profit will increase if you sell more, and reduce if your sales are down. It’s a variable, which is why it’s tracked separately.
Related: Are you sure your business is profitable?
If you run a pure service business, you have no cost of sale, so your turnover is your gross profit. Net profit takes into account all the operating expenses including salaries, rent, travel, IT costs, vehicle maintenance and everything else you need to operate the business.
There must be sufficient gross profit to cover these expenses and leave something over for profit.
- Gross profit = sales – cost of sales
- Net profit = gross profit – operating expenses
Factors like tax, interest earned and depreciation affect the final profit. I suggest you leave those to your accountant. To manage a SME, it’s usually sufficient to know the difference between your income (gross profit) and your operating expenditure.
You should get an Income and Expenditure account every month or at least once a quarter, unless you are a very small, cash-only business. Net profit is the amount of money the business makes. Net profit rewards the entrepreneur for the capital and effort he or she has put into the business and the risks they take.
In basic terms, capital is the money you put in to start the business, and retained profits since then. A net loss will reduce this capital and if this happens all the time the capital will all be consumed, the business will be unable to pay its accounts or employees, and will cease trading.
Where do the profits go?
Profits can be paid out or used in the business. Profits can go to shareholders as dividends but good entrepreneurs will reinvest some or all of the profits in developing the business by increasing skills, building the brand and becoming more competitive.
You could do this with training, marketing or new systems, machinery and equipment. You could increase salaries or pay staff bonuses, or you could keep profits as a reserve for bad times.
Choosing which of these options, or which combination of them would be right for you will depend on the reasons for current profits. If you have steadily increasing profits, you may want to reward your staff and shareholders for their contribution. Alternatively, if you have a big windfall profit you could use some of the profit to buy smaller competitors or develop new product ranges.
Related: 12 Business financial resources and profit tools
How to increase gross profit
Gross profit can be boosted by selling more, or by buying or manufacturing smarter and so reducing the cost of sale. Price increases will have the same effect, but they should be selective, based on the competition and the demand for each product range.
Increase some prices and leave others the same or even reduce some. Aside from increasing the gross profit, you can increase net profit by cutting expenditure.
Improving gross profit is likely to have a much bigger effect on your profit than trying to reduce operating costs like travel, entertainment or stationery.
Profit is not only a matter for accountants, or something you only consider at year-end; it is a vital part of management information, which you should have regularly to run your business effectively.
Copyright is owned by Entrepreneur Media SA and/or Entrepreneur Media Inc.
All rights reserved. Click here to read our editorial disclaimer.