Understanding Profit: What Business Owners Need to Know
More sales do not automatically mean more profit. A business can bring in more money and still struggle if its costs are growing just as quickly. Understanding profit gives independent business owners a clear picture of whether the business is actually making money and where changes might need to be made.
For business owners, understanding the difference between revenue and profit is essential for making sound decisions. Revenue is the money the business brings in; profit is what remains after operating costs are deducted.
This guide outlines gross profit, operating profit, net profit, and profit margin in plain language so that business owners can learn how to use these numbers to identify opportunities to improve the business.
Revenue Is Not the Same as Profit
One of the most common mistakes new business owners make is treating revenue as if it were profit.
Revenue is the total amount of money a business earns from selling its products or services before expenses are deducted. If the business sells $20,000 worth of products in a month, the revenue is $20,000.
That does not mean you made $20,000.
The business might have spent money on inventory, materials, employees, rent, insurance, software, advertising, utilities, loan interest, and taxes. After those costs are accounted for, the amount left is the profit.
For example, imagine a landscaping company brings in $10,000 in revenue during one month. It spends $3,500 on labor and materials directly related to its jobs and another $4,000 on operating expenses such as insurance, equipment payments, fuel, advertising, and software.
The company did not make $10,000. The profit is what remains after those costs are paid, so in this example, the profit would be $2,500.
Understanding revenue vs. profit helps you look beyond sales and ask a more important question: Is the business keeping enough of what it earns?
What Is Gross Profit?
Gross profit is the money left after subtracting the direct costs of producing a product or delivering a service from revenue.
The basic formula is:
Revenue − Direct Costs = Gross Profit
Direct costs are expenses directly connected to what you sell. For a restaurant, this might include food ingredients. For a construction company, it could include materials and labor for a specific project. For a retailer, it could include the cost of purchasing inventory.
For example, if a business has $10,000 in revenue and $4,000 in direct costs, its gross profit is $6,000.
Gross profit helps you understand whether the products or services are priced appropriately in relation to what they cost to provide.
If gross profit is too low, selling more may not solve the problem. You may need to review the pricing, reduce direct costs, or reconsider which products or services are most profitable.
What Is Operating Profit?
Operating profit looks at what remains after subtracting the ongoing expenses required to operate the business.
These expenses may include rent, utilities, insurance, software, advertising, administrative costs, and other overhead expenses.
Starting with our previous example, a business has $6,000 in gross profit. If it has $3,500 in operating expenses, it has $2,500 in operating profit.
Operating profit gives the owner a better picture of how efficiently the business is operating before considering certain other expenses, such as interest and taxes.
This number can help the owner identify whether the day-to-day business operations are sustainable. If sales are increasing but operating profit is shrinking, the expenses may be growing faster than the business.
What Is Net Profit?
Net profit is the amount left after all applicable business expenses have been accounted for.
The calculation can include operating expenses as well as expenses such as interest and taxes, depending on the business and accounting method being used.
Think of it as the bottom-line result of the business activity for a specific period.
For example, suppose the business has $10,000 in revenue. After direct costs, operating expenses, interest, taxes, and other applicable expenses, you have $1,800 remaining. The net profit is $1,800.
Net profit is one of the most important numbers for understanding whether the business is financially successful.
However, one month's net profit does not tell the whole story. It becomes more useful when you compare it with previous months or years and look for trends.
How to Calculate Profit Margin
Profit tells you how many dollars the business made. Profit margin tells you what percentage of the revenue became profit.
The basic formula is:
Profit Margin = Profit ÷ Revenue × 100
For example, if the business has $10,000 in revenue and $2,000 in net profit:
$2,000 ÷ $10,000 × 100 = 20% net profit margin
That means the business kept 20 cents of every dollar in revenue as net profit.
The owner can calculate both gross and net profit margins. Looking at percentages can make it easier to compare the performance over time, even when the sales change.
For example, a business may increase sales from $10,000 to $15,000 but see its profit margin fall from 20% to 12%. The business is selling more, but it is keeping less of each dollar it earns.
That is important information.
Profit vs. Cash Flow
Profit and cash flow are related, but they are not the same thing.
Profit measures what the business earns after expenses. Cash flow measures the money moving into and out of the business.
A business can be profitable on paper and still have difficulty paying its bills if cash is tied up in inventory, customers have not paid their invoices, or the business has large payments due.
For example, a contractor might complete a $20,000 project and record the revenue, but the customer may not pay for 30 days. Meanwhile, the contractor still needs money to pay employees, purchase materials, and cover other expenses.
That is why understanding both profitability and cash flow is important.
To learn more about managing the timing of money coming into and leaving the business, see our guide to Cash Flow Basics.
What The Profit Numbers Can Tell You
The profit numbers are more than accounting information. They can help the owner make business decisions.
If the gross profit is declining, look at the direct costs associated with the products or services. Are materials becoming more expensive? Are the products or services priced high to cover the cost of providing the service?
If the gross profit is healthy but the net profit is shrinking, look at the operating expenses. Are rent, payroll, software, advertising, or other overhead costs increasing?
The owner can also compare the results over time. Reviewing the numbers monthly or quarterly can help you spot trends before they become larger problems.
The goal is not simply to calculate profit. The goal is to understand why the profit is changing and decide what action to take.
Ways to Improve Profit Without Simply Selling More
Increasing sales is one way to increase profit, but it is not the only way. In some cases, improving profitability may come from making changes to the way prices, operations, or spending.
Start by reviewing the pricing. Make sure the prices account for the direct costs of providing the products or services as well as the other expenses required to operate the business.
Next, look at the direct costs. Are there opportunities to negotiate with suppliers, reduce waste, improve efficiency, or change how work is completed?
Then review the overhead expenses. Look at recurring costs such as software subscriptions, advertising, insurance, rent, and other services. Make sure each expense continues to provide value.
Finally, look at the product or service mix. Some offerings may generate significantly more profit than others. Understanding which products or services contribute the most to the bottom line can help you decide where to focus the time and resources.
For more information about setting prices, see our guide to Pricing Correctly.
Common Profit Mistakes Small Business Owners Make
One common mistake is focusing only on revenue. Growing sales is exciting, but growth is not necessarily healthy if expenses are growing faster than revenue.
Another mistake is failing to track direct costs accurately. If the owner does not know what it costs to provide a product or service, it is difficult to know whether the price being charged is adequate.
Some business owners also overlook small recurring expenses. Individual subscriptions or services may seem inexpensive, but several unnecessary expenses can add up over time.
Finally, do not wait until tax time to look at the numbers. Regularly reviewing the financial information gives the owner an opportunity to identify problems and make adjustments while there is still time to act.
Make Profit Part of The Regular Business Review
The owner does not need to be an accountant to pay attention to the business's profitability. Start by reviewing the revenue, direct costs, operating expenses, and profit on a regular basis.
A simple monthly review can help you answer important questions:
- Are sales increasing?
- Are costs increasing?
- Is the profit margin improving or declining?
- Which expenses deserve a closer look?
The goal is not to create complicated financial reports. It is to understand what the numbers are telling the owner so you can make informed decisions.
Download the Profit Snapshot Worksheet to calculate the current gross and net profit margins and identify an area of the business that may need a closer look.
Know The Numbers, Grow The Business
Understanding profit is essential for making informed decisions about the business. Revenue tells you how much money comes in, while profit shows what remains after the costs of running the business are accounted for.
Gross profit helps the owner understand the profitability of the products or services. Operating profit helps to evaluate the financial performance of the day-to-day operations. Net profit shows what remains after applicable expenses are accounted for. Profit margin helps the owner see how much of each dollar in revenue becomes profit.
A business owner does not have to become an accounting expert to use these numbers. Start by reviewing them regularly, comparing the results over time, and investigating changes that stand out.
For a small business, knowing the numbers can help you make better decisions about pricing, expenses, growth, and where to focus the time.
Download the Profit Snapshot Worksheet and calculate the current gross and net profit margins.