Understanding Gross Profit, Operating Profit, and Net Profit
As a business executive, you have a wide range of tasks on your plate. Whether it is handling an employee conflict, reviewing your marketing strategy or overseeing the launch of a new product, you have many things to do and little time to do them.
We are all busy. Having said all of this, every business executive must have some operating knowledge of accounting topics like profit and cash flow. This is true even if your role is not “quantitative” or if you don’t interact with the numbers on a daily basis. Numbers matter.
Business is all about solving people's problems - at a profit.
Yes, there have been some business executives that have had immensely successful careers without having an expertise or interest in digging deep into their business’s cash flow or other financial statements. Billionaire Richard Branson famously said he never knew the difference between “gross” and “net” before he was fifty years old, and yet Branson built a business empire.
Branson was busy working on product and marketing plans, rather than focusing on topics like monitoring Virgin’s cash flow. Nonetheless, all of us cannot be Richard Branson. He is an anomaly. At the very least, we need to have a basic understanding of some of the most important accounting topics.
While accounting is a topic that requires some dedicated study, it is important to understand three basic ideas: operating profit, gross profit, and net profit. By understanding these topics, you will be in a much better position to make great business decisions that lead to faster growth, more cash flow and more financial success.
If we had to define it in one sentence, gross profit is a company’s profit after subtracting the costs associated with making and selling its products or services. Gross profit may also be called sales profit or gross income. It ultimately assesses how efficient your company is at using labor and supplies to create some product or service.
Let’s start with the basics. Your company, no matter what it sells, brings in revenue (sometimes defined as net sales on financial statements) by selling products or services to customers. Those numbers are calculated by your accountants and appear on the “top line” of your company’s income statement.
The costs associated with making and selling your company’s products or services is also called cost of goods sold. It is critical to understand what expenses are part of the cost of goods sold. Cost of goods sold comprises the direct costs that are attributable to the production of goods or services sold in a company. Further, the cost of goods sold includes direct labor costs that are used to make the good.
A simple example is illustrative. Say that your company is a t-shirt manufacturer. Your company’s cost of goods sold includes the cost of the raw inputs (cotton, etc.) to actually make the t-shirt, along with direct labor costs that are used to transform those raw inputs into a t-shirt.
Cost of goods sold does not include indirect expenses like distribution costs or sales force costs. It also does not include fixed costs like rent, advertising, or salaries for employees that are not directly involved in the production of the good or service.
By reviewing your company’s revenue and cost of goods sold, you can quickly calculate your company’s gross profit for a quarter or year. The equation is simple:
Gross profit = revenue – the cost of goods sold.
Using gross profit, you can also find your company’s gross profit margin, whose formula is below:
Gross profit margin = gross profit / revenue.
Whether you are looking at gross profit itself or your gross profit margin, you will gain a better understanding of your company’s production efficiency over time. There are other financial metrics and terms that account for other aspects of your company (for more examples, see below). That said, gross margin provides a quick and easy look at how your company produces its goods and services.
Revenue, cost of goods sold, and gross profit are all calculated at the highest part of your company’s income statement. As you travel down the income statement, you will find your company’s operating profit.
Operating profit is the profit of your company’s ongoing core business operations. It does not account for taxes or interest payments on any of your company’s debt. Operating profit is also called operating income. You may also hear it referred to as earnings before interest and taxes, or “EBIT” (pronounced “ee-bit”).
Operating profit provides a good look into a business’s profitability by accounting for all expenses that are relevant to the operations of the business. Operating revenue is revenue or sales generated from a business’s core activities. It does not include a company’s investments into other companies, as they do not constitute core operations.
While cost of goods sold only accounts for direct costs attributable to the production of a business’s goods or services, operating profit is calculated after accounting for operating expenses. Operating expenses (also called selling, general and administrative (“SG&A”) expenses) include things like rent, equipment, payroll, and insurance.
Notably, operating profit also accounts for depreciation and amortization. While depreciation and amortization are accounting concepts, they are subtracted from operating revenue to compute operating profit. The complete formula is below:
Operating Profit = Operating Revenue – Cost of Goods Sold – Operating Expenses – Depreciation – Amortization
Compared to gross profit, operating profit gives a clearer picture of the financial health of a company’s continuing operations. It is a good look at how a company is managed since it shows customer demand for the company’s goods and services and how efficiently the company can deliver those goods and services.
In addition, operating profit is a good metric to use when comparing core business operations among competitors, as operating profit does not account for a company’s debt and the amount of taxes that a company pays. In other words, it is a good indicator of a company’s core performance.
After gross profit and operating profit, we come to net profit. Net profit is further down the balance sheet than gross profit or operating profit.
Essentially, net profit is the amount of revenue kept by the company after accounting for operating expenses, interest on debt, taxes, and other various expenses. Net profit is also called net income, net earnings, or the “bottom line.” It is referred to as the “bottom line” because net profit appears at the bottom of a company’s income statement. Net profit can be distributed to shareholders through dividends or be held by the company as a form of retained earnings.
You can use the following formula to arrive at net income:
Net Profit = Total Revenues – Total Expenses
There are several key caveats when understanding net profit.
To start, recognize that net profit may not accurately reflect the overall profits of any company. This is because net profit can be manipulated through accounting tactics like aggressive revenue recognition or hiding expenses.
In addition to the above, net profit is not a measure of cash flow or how much cash a company or organization earned during a given period. For this information, you would have to consult a company’s cash flow statement, which, along with the balance sheet and income statement, comprises a company’s main financial statements.
Last (but certainly not least), net profit greatly varies by company and by industry. If you intend to compare your company versus others in your industry, it is more helpful to use operating profit or profit margin, which is calculated as net income divided by total revenue for a given period of time.
Ultimately, net profit is a useful metric when analyzing a company’s revenues and expenses. That said, net profit isn’t a great metric when evaluating cash flow, so you will need to consult your company’s cash flow statement when analyzing how much cash is entering and leaving the company.
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If you don’t have a background in accounting, it may be difficult to understand and use accounting concepts. Since you already have enough on your plate, it is easy to shift time dedicated to understanding basic accounting concepts to focus on other pressing matters.
Resist that temptation. Understanding basic accounting terms like gross profit, operating profit, and net profit will empower you to make better decisions—no matter your current role at your company. By putting in the hard work, you will help your company increase its cash flow and ensure consistent growth.
Whether you complete simple Google searches on common accounting terms, speak with the accountants in your office, or even take an online course, gaining a working (or even deep) understanding of accounting terms can make your life easier at the office.
So what are you waiting for? If necessary, make the time to begin your quest of accounting mastery. Get started today.