“How do I break down profit and what is the profit equation?”, you may be wondering.
The point of any business is to make money. So knowledge of breaking down profit and the profit equation will be to your advantage.
Many business people focus all of their time and energy on the creative, ideas-driven side of the business.
However, not approaching business with an analytical and mathematical mind can doom you to financial failure.
Yes, even when you have all the great ideas in the world.
To develop a solid money making strategy, first, understand the elements of profit and how profit calculates. You will also get a better idea of where your money is going.
So, learn the terms and the ideas of the profit equation. These can definitely help you make significant strides in learning the process.
The 3 Different Types of Profit
Generally speaking, profit is what you have with you after you pay off all costs, taxes, and other various expenses.
Thus, for a business to be profitable, it must bring in a good deal more than it pays in expenses.
The term “profit” is broad though. When analyzing profit, it is important to look at the three different types: gross profit, operating profit, and net profit.
Take all three of these types of profit into account and understand how their margins calculate.
You can now, more effectively, measure your business’s financial performance.
1. Gross Profit
This is also known as sales profit and gross income.
The gross profit is the revenue a company has after it pays the costs relevant to making and selling a product.
The gross profit equation is revenue minus the cost of goods sold.
Project materials, sales commissions, and equipment are all part of the total labor and supply costs.
It also includes production site utilities and any other adjustable costs. They all go into determining gross profit.
Fixed costs such as rent, advertising, and salaries for employees do not go into calculating gross profit. They’re not involved in the production.
To get an idea of your company’s production efficiency over time, use your gross profit to calculate the gross profit margin.
Calculate the gross profit margin by subtracting the cost of goods sold (COGS) from gross profit. Then pide that number by the gross profit. You will see this as a percentage.
2. Operating Profit
Operating profit measures the profit that the company earns through its recurring business operations.
It excludes any extraordinary income and expenses, such as taxes, interest payments, and any outside company investments.
Business people usually refer to this as operating income or earnings before interest and taxes (EBIT).
Operating profit offers a better idea of a company’s profitability than gross profit does. It measures the efficiency of the core business by removing costs of production. The operating profit equation is gross profit minus operating expenses.
Gross profit is revenue minus cost of goods sold. To measure your return on sales, you pide operating income by net sales revenue.
Sales are otherwise known as your operating profit margin. This will give you a good idea of how risky your current business model is. It will also let you know how much you are making on sales.
3. Net Profit
Net profit is the income you have remaining after you pay all expenses (operating expenses, taxes, interest). Your net profit is your bottom line.
Simply put, the net profit equation is total revenue minus total expenses.
If you pide your net income by your net sales, you get your net profit margin. This can help gauge how much out of every dollar of sales a company actually generates in earnings.
It can be an effective measurement for determining your profitability.
Profit Margin vs. Profit Percentage
Profit margins, just like profit, can provide you with insight into a whole host of things. Things that tell about the financial health of your company.
They can clue you in on the success of your sales model. They’ll even give you an idea of industry standards.
But because profit margins calculate as percentages, you may confuse them with another measurement: profit percentage.
Profit percentage specifically establishes the profit a company makes through sales.
This is versus the profit it makes relative to total expenditures. You can get this value by piding the net profit on sales by the cost price. This is a helpful calculation, but not quite the same as a profit margin.
The Importance of Understanding Profit Equation
It’s easy to simplify profit as “this is how much money I’m raking in,”. Understanding what goes into calculating your profit and your profit margins and what the results mean can help determine the health of your company.
Like any metric though, these things don’t consistently present the full picture. Just because your margins are low, it doesn’t mean you will necessarily be unprofitable.
As with any facet of business, it’s important to look at both the specific measurables while also considering the larger scope. When it comes to grips with your company’s financial future.