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Before today, you may have thought the terms “gross profits” or “gross margin” were kind of… well, gross. You’ve seen so much terminology out there about “profitability” that it makes you want to slam your face on your keyboard every time you drown in accounting jargon.

What the heck do these terms all mean anyway, and how does it relate to your business?

If your face looks like Kevin every time you see these words, have no fear — I’m here to provide the clarity to your confusion in a no-BS way you’ll finally understand.

>> Also Read: What’s the Difference Between Cash Flow & Profit?

First, let’s define “Profit”.

Profit simply means revenue that is left over after deducting expenses.

The thing is, “profit” can be calculated at many levels depending on how you want to look at the numbers — it’s the different terms that describe each level (sometimes used interchangeably) that tends to cause people confusion!

In a simple product or service business, there are 3 main terms you’ll need to wrap your head around: Gross Profit, Operating Profit and Net Profit.

LET’S BREAK IT DOWN — 👇 Click the headers below to expand 👇

GROSS PROFIT

Gross Profit is what your business makes after deducting all costs directly related to making and selling its products (Cost of Goods Sold*), or providing its services (a.k.a. Cost of Sales, for service businesses).

Gross Profit
Revenue — Cost of Goods Sold
 a.k.a.  Sales Profit, Gross Income

➤ What it Measures:

The financial success of your products or services. Look here to see where you can increase prices or shave production costs to boost overall profitability.

“COGS” includes production-related costs such as:

  • cost of raw materials and supplies
  • shipping costs from suppliers
  • direct labor (if you have dedicated production staff)

Basically, these are costs you would only incur when producing your product.  They would NOT include general operating costs such as administration or selling costs, which I’ll explain in the next section.

*Note: If you’re a product manufacturer, determining COGS could be complex, as it is based on the valuation of your inventory. It’s best to consult your accountant to make sure this number is calculated correctly.

OPERATING PROFIT

Operating Profit is what the business makes after deducting all non-production related costs. It doesn’t consider passive income from investments, or interest and tax expenses, which are usually reported on seperate lines on the income statement.

Operating Profit
Gross Profit — Operating Costs — Depreciation and Amortization*
 a.k.a.  operating income, earnings before interest and tax (EBIT)

➤ What it Measures:

What you’re making from your core business operations. Look here to see where you can reduce general and administrative costs (not related to how much you sell) to boost profitability.

“Operating costs” include things such as:

  • rent
  • equipment
  • inventory storage costs
  • marketing
  • payroll for non-production or support staff
  • insurance
  • general & administrative costs
  • These are costs necessary to run your business and keep the lights on, and doors open, regardless of how much you produce.

    * Note: Depreciation and amortization are calculated on the use of your fixed assets and equipment (ie. furniture, computers, etc.). Your accountant will help you determine these amounts. There may also be different numbers for accounting and tax purposes.

    NET PROFIT

    Net Profit is the REAL bottom line — it’s the amount of earnings left after deducting all expenses, interest and taxes. This money can either be reinvested back into the business, or go in your pocket!

    Net Profit
    Operating Profit — Interest — Taxes
     a.k.a.  Net Income, Bottom Line

    ➤ What it Measures:

    The REAL BOTTOM LINE — Your business’ overall ability to convert sales into profit.

    What are “Margins”?

    Margins show profits as a percentage of revenues. You can think of this as the % of every dollar of Revenue that remains as Gross, Operating, or Net Profit.

    It’s often easier to talk about profitability in terms of percentages (margins), rather than actual dollars (profits) because your sales and expenses could fluctuate from month to month — a percentage better shows your efficiency.

     INSIGHT:  It’s totally possible to have your margins increase from one period to another, even if your sales were lower — this means you were producing or operating more efficiently, and keeping more of every dollar you made in your pocket! #FTW

    Looking at profitability as a percentage also makes your results more comparable to prior periods, or even to other businesses, so you can see how you stack up against your competitors, or the industry average. Different types of businesses will have varying ranges of what’s considered “good” — it’s worth researching this so you have a sense of what is realistic to aim for.

    There’s a margin calculation at each level of profit:

    ➤ What it Measures:

    How efficient you are at producing the products or providing the services you sell.

     

    ➤ What it Measures:

    Overall effectiveness from core business operations.

     

    ➤ What it Measures:

    Bottom line profitability — The % of every dollar in revenue that stays in the company after all expenses are considered.

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    An Example to Tie All This Together:

    Below is a sample income statement from a photography company — assume Jane is a solopreneur with no employees. Let’s look at how her operations looked at the end of one year.

    Notes:
    * COGS includes: job-related product costs, job-related travel, packaging, shipping, and credit card fees

    ** Depreciation is calculated based on estimates of useful life and salvage value — verify these expenses with your accountant to make sure you do this right!

    ➤ What This Shows:
    • Gross Margin of 80% — Jane’s a lean, mean, picture-taking machine! Her costs related to performing her jobs are low, since $0.80 of every $1 earned is left over to absorb other operating expenses. There’s lots of room to scale up.
    • Operating Margin of 61% — After considering her overall operating costs, Jane keeps $0.61 of every $1 made. Since operating costs aren’t directly related to the amount of work she takes on, she has some room to boost her profitability by reducing some of these costs where she can by bootstrapping.
    • Net Margin of 51% — After paying interest on a bank loan, and income taxes, Jane ends up with a little over half of what she makes in her pocket.

     

    For More Insight: Review your margins at different levels

    ➤ A detailed level — by each type of service, or each product you sell, so you can understand which ones are the most profitable. Focus on pushing those!

    ➤ An aggregate level — calculate margins on total revenues each month or quarter (like we did in the above example), to see how you’re doing overall

    Even if your revenues and expenses fluctuate from year to year (this is normal!), looking at margins will give you powerful insight into how efficient you are at keeping more dollars in your pocket. If the percentages are on the rise over time, you’re #winning.

     

    BOOM.

    And that’s it, my friends — Venture forth and proceed with confidence now that you know these concepts.

    You’ll now be able to drop lines when discussing with your accountant by saying things like:

    I increased my hourly rate — This gave me an increase of $10k in gross profit, and a 2% boost in my gross margin compared to last year!

     

    Heck, you might even like looking at your numbers when you see the margins climb, and you get better and better at doing your thing.

    Don’t say I didn’t warn you,

     

     

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