Knowing the difference between gross profit and net profit matters for 2 main reasons:
- You buy things to resell
- Your costs increase every time you make a sale
And that’s because it records the difference between your sales and what is costs you directly to make those sales. That difference represents your sales margin or markup. It is the first indicator of profitability in a business.
A while back I was watching an episode of Dragons Den (called Shark Tank in the USA) that reminded me of the confusion that abounds around the words: turnover, gross profit, net profit, profit margin, EBITDA and a bunch of other terms that have everything to do with how you view the profitability of a business.
Contestants on that show almost always fail when they get their numbers wrong (or worse – they don’t know what they mean). But luckily it’s easy. Read on…
Turnover or T/O (Total Sales)
This is your total sales figure. Literally, in money terms, how much you sold during a particular period (usually your financial year). Add up every bit of money that comes into the business with the exception of Sales Tax/VAT, loans, sale of capital items, and interest received and that is your turnover.
The reason loans, capital items and other money is not included is because they are usually not a core part of a business. So whatever it is a business sells as a normal part of its trading activities represents its turnover.
Turnover To Date means the turnover so far this financial year. From this you can start to make a prediction of your total turnover for the year. For example, if you’re 9 months into your year and your turnover to date is 75,000, then you can predict with some degree of certainty that your total turnover for the year will be 100,000.
If you have professional indemnity insurance you will need to have an idea of your forecast turnover for the current year. Most policies allow a degree of error of 50% (to make up for the uncertainty factor), but check your insurance small print.
Never confuse turnover with profit. Always quote turnover excluding VAT (or Sales Tax in the USA). If you quote turnover including tax, any potential investors will run a mile (they will see you as someone who likes to inflate figures). Sales Tax and VAT is not your money (you are just collecting it on behalf of the government) so it should never be included.
If all you sell is a service. And there are no costs directly involved in supplying that service, then your gross profit is the same as your turnover.
However, if you resell goods or services, manufacture things for resale or have costs directly involved with selling what you do, then you need to remove those costs from your sales in order to arrive at your gross profit.
Typically these costs will be held in an account called Cost of Goods Sold (aka COGS). If you sell mainly services, this is often shortened to simply Cost of Sales (COS).
Here’s a simple example: You buy a widget at a cost of 100 and you resell it for 200. If you sell just one of these, your turnover will be 200. However, your gross profit will be 100 (because you must subtract the cost of the goods sold).
Other direct costs include shipping or postal costs (as these will not be incurred if nothing is sold). They will also include packaging of those goods, and if you manufacture them yourself, all the costs involved in that process (we know they are direct because unless you manufacture them, you won’t have anything to sell, plus everything you manufacture is for resale).
Compare this to the costs of renting your office and heating and lighting it. You have to pay all those costs whether or not you sell a thing. These costs are termed overhead costs. Salaries and wages are also part of your overhead so are not included in your gross profit calculation. These items are included later to determine your net profit (see below).
Gross margin measures the gap between what it cost you to produce a product (or buy it for resale) and how much you got for it when you sold it.
Using the previous example, the gross margin is 50%. Gross Margin = (Selling Price less Cost Price) divided by Selling Price multiplied by 100.
As another example, if you sold a product for 200 which cost you 160 to buy or manufacture, your gross margin would be 20%. Here’s the filled in gross margin equation of that last example: (200 – 160) / 200 x 100 = 20
Like gross profit, knowing your gross margin is vital. And that means knowing with a good deal of accuracy your cost of goods or cost of sales. If you don’t know what it costs you to buy, manufacture and ship something, then you cannot set a price that you know will return a profit (and this is why so many contestants in Dragon’s Den and Shark Tank get eaten alive!).
Markup is another way of talking about margin. If you buy a product for 100 and you resell it for 200, you have marked it up 100%. If you bought something for 100 and wanted to mark it up by 25%, the selling price would be 125.
Most retailers operate on a markup of at least 100%. The exception is for commodities where the competition is usually so fierce, everyone is forced to compete on price.
Certain luxury goods also have the same problem, but in a different way. For example, Apple sell both online and in retail stores. They fix their own prices and ensure those prices remain high everywhere by selling on goods to other retailers with only a small discount. Note that price fixing in any other way (eg. trying to force your resellers to sell at a certain price) is illegal in most countries.
Be warned. There are multiple versions of Net Profit. The bottom line is your turnover less all costs. Your costs are not only Cogs and overheads but also depreciation of your assets, any amortisation of loans and just as importantly the tax liability on any profit made.
Accountants use different abbreviations to show exactly what degree of profit they are reporting. The most common is EBITDA.
EBITDA is an acronym for Earnings Before Interest, Taxation, Depreciation and Amortisation. In other words your turnover less COGS, overheads and other expenses. EBITDA is the most common way to report Net Profit.
You can quote on any subset of this. For example: EBIT = Earnings Before Interest and Taxation (so here we are including depreciation and amortisation).
Learn the above and you will impress any investor (and bank manager).
NOTE: Find out more about profit, loss and other accounting and bookkeeping jargon with our free Definitive Guide to Bookkeeping below
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