Understanding profit and profit margins is critical for business owners and corporate decision makers to reach their ultimate goal - earn the money they need to be successful and grow their company.
That goes the same for a small-business owner who starts a web design business in her basement or a high-profile chief executive officer who runs a multi-billion global business.
To succeed, each has to earn enough money to make a profit, and to earn enough to keep the business prospering, for themselves and their families, their employees, their shareholders, and their communities.
That's exactly where calculating profit comes into the picture.
What Is a Profit?
In a word, profit is the amount of money a company, large or small, earns against the money it spends running the business.
Often known as net income, profit is the cash leftover after every one of those business costs is deducted over a specific period of time (known as the "accounting period."). For example, most publicly-traded companies measure their profits on a quarterly basis, by issuing earnings reports that benchmark their profits and losses.
Profits are often used as a measuring stick for how a company is performing. If profit margins are high, it usually shows that management is making the right calls, the company is manufacturing or selling the right products in the right way, and that the vision the company has for the future is correct, and should be used as a blueprint going forward.
Correspondingly, low or no profit, or worse, financial losses, usually mean that the company could be facing significant problems, including shoddy management, weak demand or disinterest for the product or service it offers, and inadequate sales and marketing efforts.
There's no question that profit is the ultimate goal for anyone in business. If you're not making money, your company may well have a short shelf life, so getting profit right and getting them measured correctly is a big deal in business.
Are Profits and Revenues the Same?
Profits and revenues are similar in that both measure cash coming into a company, but that's where the similarity ends.
Let's examine both profit and revenues and see how they differ - and why that distinction is important:
Profit. Again, profit is the financial measure that is used to measure a company's performance. It's the cash leftover after every business expense has been recorded over a specific period.
Revenue. Revenue is the amount of cash a business takes in the course of doing business.
While revenue represents all income coming into a business, profit is the important figure on a financial statement - it shows what remains after a company makes good on all its bills.
That's why revenue can't be used to accurately benchmark the financial performance.
Yes, it's important to record revenues, as you want to know the amount of income your company is generating directly from your products or services. But revenue doesn't tell the story that profit does - you can have strong revenues, but your company may still record a loss if the money you have flowing out of your company exceeds the money you have flowing into the company.
Different Types of Profit
There are different forms of profit that all business decision makers should know about, and know how to measure:
- Gross Profit. Gross profit is a category on a company's income statement that records total revenues minus the cost of products or services sold by a business. In accounting lingo, gross profit is a business's profit before operating expenses, interest payments and taxes are included.
- Operating Profit. Another key category on a company's income statement, operating profit is the amount of money remaining after deducting the expenses used to operate a company from the business's gross profit. Normally, expenses stem from three business areas - sales, general and administrative-related expenses.
- Net Profit. Also known as net income, net profit is the amount of cash remaining after operating expenses have been subtracted from a business's total revenue. Operating expenses that need to be deducted include interest, taxes, and preferred stock payments. Basically, net profit means the money a company earns after business costs and expenses are paid out.
- Economic Profit. Economic profit is the variance between revenues collected by a company against the opportunity cost in doing business. Companies opt for different business strategies all the time with multiple possible outcomes in doing so. In that regard, economic profit is the amount of cash a business earns after choosing one business strategy over another business strategy the company could have chosen - but didn't.
What Is Profit Margin?
A profit margin is a figure representing the profitability of a company, expressed as a percentage on the company's income statement. The stronger the percentage, the more money the company is earning, after all expenses are 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 leads to a weak gross profit margin, company decision makers may well have to adjust product or service pricing upward.
Gross profit margin is calculated by deducting the cost of products sold from net sales. Then, divide the number left into net sales to calculate the percentage, or ratio, representing the gross profit margin.
How to Calculate Net Profit Margin
Net profit margin calculates just what it suggests - a company's total profitability, on all of its products and services. Like any profit margin, it is expressed as a percentage.
A robust net profit margin suggests the company is on the right track and that it's growing over a specific (usually quarterly) time period in a healthy way. A low net profit margin is usually an indicator of problems that may include poor management decisions, weak demand for products and services, high costs, and ultimately, weak sales and poor revenues.
Net profit margin is calculated by dividing a business's net income into total sales, and then multiple the result by 100. A company's net margin calculation includes all of a company's costs and revenues.
Overall, the proper calculation for net margin is as follows:
Profit Margin = Net Income/Net Sales (revenue)
Examples of Profit Margin Calculus
Here's an example of a gross profit margin calculus:
Remember, the gross profit margin is gross profit/total revenue times 100.
- A company's revenues are $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%
With total net profit margin, a company will add, for example, $10,000 for the rest of a company's expenses. Adding that figure into the calculus will yield a net profit margin of 10%.
$10,000 (additional expenses)/$100,000 x 100 = 10%
Getting It Right
Understanding how profit impacts a company, and how it is calculated is a financial priority for company decision makers. Getting it right could be the difference between a company that is on the path to success, and a company that has a bleak - and short-term - financial future.