Gross profit and gross margin are two key numbers in every business. They are also…
Why Gross Profit Is Not Bottom Line Profit and Does That Matter?
Numbers are the tools we use to track how well our business is performing. There is no need to know the intricacies of how accounting works. What is important, though, is to understand key numbers that impact your business.
One of the areas I find confuses many owners is the difference between what accountants call Gross Profit or Gross Margin and Profit or Net Profit or what I call Bottom Line Profit.
Now before you run for the hills, let me promise you that this isn’t nearly as hard as you think it is. Bear with me and we’ll go through this step-by-step together now.
Step 1: Income
This one is simple; it’s all the sales you’ve made during a particular period of time. If you are selling products, you will call your income sales. If you are selling services, you will call your income fees. Both are income.
Step 2: Cost of Sales
- If you are selling products, your cost of sales is the amount you’ve paid your suppliers for the products plus any freight and delivery charges. If you re-package the goods, this will also include the packaging materials and associated costs. For example, if you have a floristry business, the cost of sales will include the cost of flowers, wire and foam, gift tags, paper and plastic wrapping, ribbons and so on.
- If you are selling services, your cost of sales is the cost of your staff and contractors who provide those services, in addition to any costs specific to providing the services. For example, if you have a motor mechanic business, the cost of sales will include the wages and superannuation of your mechanic employees, in addition to the cost of parts used in the services.
Step 3: Gross Profit
Take your Income figure and subtract the Cost of Sales figure and the difference is Gross Profit. This is a dollar value figure.
Step 4: Gross Margin
Take the Gross Profit figure, divide it by your Income figure and multiply the answer by 100. This will give you the Gross Margin percentage.
So now you have a dollar value of Gross Profit and a percentage for Gross Margin. Both numbers are important. I’ll explain how to use these in a minute.
Step 5: Overhead Expenses
These are all the other expenses of the business that are not directly related to making the sales or fee income. Many of these costs will be fixed costs like rent and insurances, whilst others may be variable like electricity and stationery. Overhead expenses generally include the following categories of expenses:
- sales & marketing (e.g. advertising, promotions)
- occupancy costs (e.g. rent, electricity, cleaning)
- staff costs (those not included in cost of sales – e.g. admin staff, plus amenities, training )
- insurances (e.g. business, workers compensation)
- finance costs (e.g. bank fees, merchant fees, interest on borrowings)
- vehicle cost (e.g. petrol, services, registration)
- consultants (e.g. accountants, advisors, lawyers)
- general expenses (e.g. printing & stationery, postage)
Step 6: Profit
Take your Gross Profit figure and subtract the Overhead Expenses figure and the difference is Profit. Profit can also be called Net Profit and I refer to it as Bottom Line Profit. This is a dollar value figure.
So Why Do These Numbers Matter?
Focussing on specific numbers in your business will give you a better understanding of what is happening within the business. In addition, when you know these numbers, you are in a better position to make changes to them to improve your overall trading results.
Focus on the Gross Margin percentage by looking at ways of reducing the cost of sales, buying product at a lower cost, improving the efficiencies of staff and on the flip side, looking at whether you can increase the sales price or fee revenue. By increasing revenue and/or reducing costs, you will increase the Gross Margin. The higher the Gross Margin the better.
Focus on the Gross Profit by looking at how the amount compares to the overhead expenses and the Bottom Line Profit. The more the Gross Profit figure, the bigger the Bottom Line Profit. In addition, finding ways to reduce the overhead costs will also increase the Bottom Line Profit.
Now, go and have a look at your figures, make a note of what they are now and then work to improve them.
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