accounting

# Understanding Gross, Operating, and Net Profit

If you want your small business to survive, much less thrive, you need to focus on making it profitable. A solid business plan lets you lay out a road map to reach your goals and build one success on top of another. That’s why it’s important to set milestones that show you where you sit on your journey. A key part of that comes down to understanding the differences between gross, operating, and net profit, as well as how to calculate these figures. This gives you a foundation for creating important financial reports such as income statements, tracking your company’s financial health with ratio analysis, and helping you better set a profit target that gets you to your next goal.

## Gross Profit

Gross profit reflects your revenue minus the cost of the goods or services you sell. This figure shows you how efficiently you use your company’s resources. In this instance, revenue includes all the money you take in with no deductions, while costs represent costs that differ depending on your output, or variable costs. These costs include direct labour, supplies, sales commissions, fees, utilities with variable pricing such as electricity and water, shipping, and appreciable equipment.

If your small business takes in \$100,000 and it costs you \$70,000 to make the goods or services you sell, you have a gross profit of \$30,000. This breaks down as (\$100,000 – \$70,000 = \$30,000).

## Net Profit

To figure your net profit, you must first know your gross profit. You calculate your net profit by subtracting your fixed costs from your gross profit. Fixed costs include things that cost the same amount each month, including rent for your building, salaries for management, property taxes, utilities such as internet and phone service, property taxes, and insurance.

To continue with the example above, imagine your company has \$15,000 in fixed costs. To figure your net profit, you subtract the \$15,000 in fixed costs from your \$30,000 gross profit, giving you a net profit of \$15,000.

## Operating Profit

Operating profit reflects the amount of money you make from your company’s operations. Also known as earnings before interest and taxes (EBIT), this calculation subtracts your fixed costs from your gross profit, and then subtracts amortization and depreciation from the total. Amortization refers to costs associated with intellectual property assets such as copyrights, patents, and licences, while depreciation refers to purchases for business-related assets with a useful life of more than a year.

Using the same example, imagine you pay out \$2,500 for intellectual property (amortization) and \$2,500 for equipment (depreciation). To figure your operating profit, you add their total of \$5,000 to your fixed costs of \$15,000 for a total of \$20,000. Then you subtract that from your \$30,000 in gross profit. This means you have an operating profit of \$10,000, or (\$30,000 – \$15,000 – \$2,500 – \$2,500).