Your business has several different types of margins, and it pays to understand all of them.
Bret Bonnet is embarrassed to admit it, but he didn’t always understand gross profit margin, how to properly calculate it, and how it differs from net and operating profit margins. “If I was making money, I was happy,” confesses the president of Quality Logo Products.
This misunderstanding caused Bonnet and his team to discount products too steeply—a costly mistake. He explains how they used to calculate their online pricing: “Let’s say an item was on sale for $100 (to the customer) and our net price was $50. For whatever reason, instead of figuring out our net price or cost of goods sold (COGS) and then applying a mark-up percentage on top of that, we applied a discount percentage to the customer price. We’d adjust this percentage until our customer pricing was competitive in relation to the marketplace, never paying attention to our actual net price or what we now know to be our profit percentage. Yeah. Embarrassing.”
Bonnet realized his mistake and adjusted his calculations and pricing accordingly. And he is not alone. Many business owners either fail to understand all of the key performance indicators (KPIs) that can affect their business, or they underestimate their importance. Here’s a closer look at gross profit, operating profit, and net profit margins.
Gross Profit
Gross profit = Gross revenue - COGS
Gross profit margin = Gross profit / Gross revenue
Gross profit is also called sales profit and gross income, and it is used to assess sales in relation to the cost of labor and materials. Although it is “a good macro level indicator of success,” it doesn’t take into consideration other expenses, such as the wages of your sales team, warns Bonnet.
Since gross profit margin is a percentage, it is useful for comparing performance over time and assessing efficiency, even if sales and/or COGS have changed.
Operating Profit
Operating profit = Gross profit - operating costs
Operating profit margin = Operating profit / Gross revenue
Operating profit is also known as earnings before interest and tax (EBIT). Unlike gross profit, it factors in operating costs. “Operating profit margin is basically the proportion of money left over after paying off fixed expenses,” says Bonnet. “Operating profit margin shows a company’s efficiency at controlling costs. It’s one thing to have a healthy gross profit margin, but if it’s not enough to cover expenses like payroll, advertising, and more, you are in trouble.”
Net Profit
Net profit = Revenue – COGS – operating expenses – interest and taxes
Net profit margin = Net profit / Gross revenue
Net profit margin takes all expenses into consideration, including operating expenses, taxes, and interest paid on debt. “It reflects a company’s profit per dollar of sales” explains Bonnet.
These margins are key to assessing the health of your small business. Remember, higher sales don’t always mean greater profitability. More important than how much money you are bringing in on the top line is the state of your bottom line after you factor in all your costs. Doing a better job of controlling expenses can have as dramatic an impact on profit as boosting sales, so it’s important to understand the relationship between what you are making and what you are spending. Even a company with a healthy gross profit margin could be losing money if other expenses like labor and utilities are high, notes Bonnet. “Revenue means nothing without profit,” he says. “There is no real net profit unless there is money left over after paying all your bills.”
