As a small business owner, profit is always on your mind. Every decision, whether you’re managing a cozy shop around the corner or running a growing enterprise with a few employees, revolves around generating profit. But simply chasing profit isn’t enough in today’s business landscape.
If you have plans to grow your business, learning the language of finance professionals is also important. While the basic definition of profit is easy to understand, it can take on multiple meanings in the world of finance. Understanding the types of profit and how to calculate them is crucial for making informed business decisions.
What Is Profit?
Before we look into the different types of profit, let’s ask the main question itself – what exactly is profit?
Well, as finance experts like to put it, profit is whatever money you have left in your business account after you take out all of your expenses. You make revenue when you sell a product or service, and when you subtract your expenses from that number, what you’re left with is your profit.
In the business sense, it’s important to note that profit isn’t necessarily the same as revenue or cash. Revenue is defined as income from sales without any deduction of expenses, while cash is the money you already have in your business account before the revenues come in. At the same time, you need to remember that your overall cost includes everything you spend money on – production, delivery, inventory, and even taxes on your business operations.
At the end of every accounting season, profits earned from the business are allocated to its owner (you). You can decide to pocket the cash, redistribute the profit among shareholders (if you have them), or reinvest the profit back into the business to ensure its continuity. All of this depends on the structure of the business and its solvency.
The Different Types Of Profit
Now that we’re clear on the basic definition of profit, let’s look into the different forms it can come in. Generally, for the purpose of business operations, you have three major types of profit to keep in mind:
Gross Profit
In simple terms, gross profit is the income received from your sales minus the direct costs involved in making your goods. It is the first level of profitability, showing the difference between your income from goods sold and the cost of goods sold.
Generally, the cost of goods sold includes things like labour and raw materials. When you take all of these costs and total them, you can take the total from your income and arrive at the gross profit.
With gross profit, you’re able to ensure that your cost profile isn’t becoming too much. You’re also able to identify the potential impact of cost increases and find ways to keep your costs as low as possible.
So, remember – to measure gross profit, you get the following formula:
Gross Profit = Revenues – Cost of goods sold (COGS)
Operating Profit
Next, we have the operating profit, which takes your total gross profit and subtracts your operating costs.
You see, for every business to run, there are costs that need to be incurred regularly regardless of the level of sales. Expenses such as power, rent, fuel, salaries, insurance, etc. are incurred regardless of whether you make sales or not. And while some of these costs can be fixed, others can also be variable. In total, these expenses make up your operating costs.
After finding your gross profit, you go on to take your total operating cost profile out of it, thus arriving at your operating profit. Some accountants refer to operating profit as “earnings before interest, tax, depreciation and amortisation” (EBIT or EBITDA).
By reviewing your operating profit, you can make better business decisions – such as whether you can invest more in your business without making some cost cutbacks. It allows you to understand your regular cash flow, which in turn paints a picture of your company’s health.
So, to get operating profit, remember the formula:
Operating Profit = Revenue – Cost of Goods Sold (COGS) – Operating Expenses – Depreciation & Amortization
Net Profit
Finally, we have the net profit, which considers your operating profit minus the cost of interest and taxes that the company has to pay.
Maybe you wanted to expand your business and that meant taking a loan with an interest rate. The repayments you have to make for the loan are factored into your net profit. At the same time, it’s also important to remember your business’s tax obligations to the government as this helps you stay in compliance with the law.
Taking these two expenses, and subtracting them from your operating profit, gives you the net profit – or what many accountants refer to as your “bottom line.”
Your net profit is probably the most important kind of profit there is. It is the final indicator of your business’s health, and it shows what money your business has left at the end of a financial period after all expenses have been paid. This is the final amount of money you can choose to pocket, redistribute, or reinvest in the business.
So, remember – net profit is calculated using this formula:
Net Profit = EBIT – Interest Expense – Taxes
Conclusion
As a small business owner, knowing how to calculate and analyze these different types of profit is essential for your business’s long-term success. Understanding gross, operating, and net profit will help you make strategic decisions about reinvesting, cutting costs, and growing your business sustainably.
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