As business owners and managers we understand we need to keep track of sales and expenses to know whether we are making a profit. But when it comes to looking at your Profit & Loss (P&L) report, which sets out sales and expenses, what are all those different kinds of profit? There’s gross profit, operating profit, net profit and then your accountant might talk about the top and bottom line – it can be confusing.
In this jargon buster we’ll cover the different types of profit and what they mean. Let’s start by looking at some of the key terms you’ll see on your Profit & Loss report.
So that’s your basic P&L – now let me explain some key elements:
- The profit as shown in the P&L is not the same as cash. The profit in a P&L is based on accruals accounting – matching income and expenses in the same period based on activity (so a sale is a sale when invoiced not when the cash comes in).
- Gross profit – this is your value-add. This is at the heart of your business model and your job is to push sales and cost of goods sold as far apart as possible – i.e. to maximise gross profit whilst still giving customers a good product or service.
- Operating profit shows you the profit of “operations” before finance costs and tax. Because this line is before interest and tax, which can vary depending on interest rates and tax rates, you have a more consistent view of how the business is literally “operating”.
Gross profit margin
You will also come across the term margin in relation to profit. What this does is express the profit (gross, operating and net) as a percentage of sales to help track movements in underlying profitability. So for example:
By using the percentage you can see that while the amount of gross profit has gone up, the profitability has gone down from 75% to 70%. It may be this was planned but it could also be because of inefficiency or some other reason – it’s a good wake-up call to interrogate the figures.
Which profit matters?
We’ve covered the key terms, so the big question is which figures should you be looking at? Surely the only thing that matters is the bottom line? Well, that depends…
Of course the bottom line is crucial – all businesses need to make a profit and in a sense it is the proof that your business model is working. Without a healthy bottom line you are at risk of simply running an indulgent hobby business.
Consider this, though – what if your customers are getting restless and your proposition isn’t working as well for them anymore? In the short-term a slow down in sales might be masked by good cost control, in which case the bottom line on its own isn’t telling the whole story.
So maybe your focus should be on the top line – on sales. Indeed, a lot of businesses are now very much focused on measuring “customer delight” using tools like the Net Promoter Score. Certainly, if you take the view that the number one job running a business is to get more customers and sell them more this would make sense.
My view is that a sustainable business is based on monitoring, managing and developing all aspects of your business model. So you need to look at gross, operating and net profit and their percentage margins to ensure you are tracking the assumptions in your business model. You should also recognise the importance of “non-financial” indicators such as customer satisfaction.FreeDigitalPhotos.net]