Making a profit is a key goal for most businesses when they're starting out, as well as an important metric to be used to inform business decisions. But what kind of profit should you be tracking?
Here we explore the three main types of profit you can measure and how they can support you in making strategic decisions for 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, minus the amount of money spent on making or delivering those products or services and keeping the business running, such as paying salaries, utility bills and rent.
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 enables you to re-invest for growth, such as through expansion or new product lines, as well as withstand fluctuations in demand and unforeseen downturns. Generating cash ensures that there’s enough money in the bank each month to pay your expenses.
Different types of profit
There are three main measures of profit. These are gross profit, operating profit and net profit. Gross profit and operating profit measure how effectively your business is spending money to make its products and maintain day-to-day operations. Net profit looks at how much money your business has left after all expenses have been deducted. All three are commonly represented as a percentage, known as the margin. Let’s take a closer look.
Gross profit
Gross profit is the income from the sales of your products, minus the direct costs involved in making them, which are also called cost of goods sold (COGs). These include labour and raw materials. Gross profit enables you to check that your costs aren’t becoming excessive and to identify the impact of cost increases, such as whether you need to switch suppliers or change your pricing structure.
James Greenwell, owner of beauty and wellness manufacturing business On-Group, measures gross profit for each of his five business units every month to understand which are profitable and which are breaking even or making a small loss. Based on this data, he can decide where and how to adjust his strategy.
An example of this in action is when one of his units suffered a downturn in sales as a result of the Covid-19 pandemic.
"Pre-pandemic, we were ticking over about £35,000 per month from [sales to] bricks-and-mortar beauty salons," says Greenwell. "When the pandemic hit, that dropped to below £10,000 per month, when beauty salons were forced to close."
As a response, Greenwell made the decision to switch strategy from selling products to beauty salons, to selling them directly to consumers.
The move saw Greenwell's customer base jump from 4,000 to 40,000 customers in two years, with sales rising nearly fourfold from £300,000 to £1.2 million in that time.
Operating profit
Operating profit takes your total gross profit and deducts your operating costs from it. These 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 are variable. Operating profit is also sometimes referred to as earnings before interest, tax, depreciation and amortisation (EBIT or EBITDA).
“Reviewing your operating profit regularly will help with decision-making, such as whether or not you can afford to make investments or need to make cutbacks,” says John Edwards, CEO of the Institute of Financial Accountants.
“It may also be used as an indication of your cash flow health and your ability to borrow."
Net profit
Net profit is the final indicator of profitability. It takes into account the cost of debt to a business, income received from business investments, and taxes. This figure is then deducted from or added to operating profit. Net profit shows you what money you have left at year-end after all expenses have been paid and therefore what money you have available to re-invest.
“Net profit is what keeps the company going,” says Greenwell.
"In a good year I'm looking at between 7 and 9% net profit in the business and, if I achieve that, then I normally allocate 2% to new business models," he adds. "That can be anything from product development to buying bricks-and-mortar, launching new brands or new websites."
An example of this was Greenwell's decision to launch a new product that he believed was an opportunity to be first-to-market. By looking at net profits, he knew he could allocate up to £100,000 to its development.
Once you've decided where to re-invest your profits – whether it's in a new product or a new building – an American Express® Business Gold Card¹ can make your payments work harder for you. For every £1 spent, you earn 1 Membership Rewards® point², which can be redeemed as statement credit.
How often should profit be measured?
How often you measure profits depends on your business. For services, most costs are fixed, making gross, operating and net profit fairly static, explains Edwards. This means that a monthly check-in and quarterly deep-dive should suffice.
For other businesses, these measures will vary against factors such as fluctuations in market prices, variance in stock levels, and demand. In this case, you should think about measuring profits weekly, or even daily, as the data should inform short-term decisions such as stockpiling resources when the market is in your favour, or boosting marketing spending.
“Where businesses often fall down is that they prioritise the measurement of figures but not the relevance of those figures to the business,” says Edwards.
1. If you'd prefer a Card with no annual fee, rewards, or other features, an alternative option is available – the Business Basic Card.
2. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
Certainly! I'm well-versed in financial matters and particularly adept in dissecting profit metrics. The article succinctly breaks down three vital profit types: gross profit, operating profit, and net profit. Here's a deep dive into each concept:
1. Gross Profit: This measures income from product sales minus the direct costs of producing those goods (cost of goods sold - COGs). It's a crucial indicator to monitor excessive costs and the impact of price changes or supplier shifts. For instance, James Greenwell's experience illustrates how adapting strategy based on gross profit data aided in pivoting sales strategies during the pandemic, leading to remarkable growth.
2. Operating Profit: This figure deducts operating costs from gross profit, encompassing day-to-day expenses like rent, utilities, and insurance. Regularly reviewing operating profit helps in crucial decision-making processes such as investment feasibility and financial health evaluation, as mentioned by John Edwards.
3. Net Profit: The final indicator of profitability, net profit, accounts for business debt costs, investment income, and taxes. It reveals the surplus available after all expenses, serving as the basis for re-investment decisions. James Greenwell's strategy of allocating a percentage of net profit to new ventures highlights how this metric shapes business expansion.
The article also touches upon the frequency of profit measurement, highlighting the importance of tailoring measurement intervals to suit the business model. For service-oriented businesses with relatively fixed costs, a monthly overview suffices, while businesses sensitive to market fluctuations might necessitate more frequent assessments.
In essence, understanding these profit types and their implications empowers businesses to make informed decisions regarding expansion, cost management, and investment strategies, all contributing to sustained growth and resilience in a dynamic market environment.
