Some accounting jargon can be confusing. I am an accountant and most of the time I understand what someone is asking, but for a normal business owner it might as well be Latin or jibberish. Our job is to convert accounting-ease to plain English. You know so you can actually understand what we are trying to show you.
One of the concepts I often see small business owners get tripped up by is the difference between gross profit and net profit.
Why do I need to be concerned with understanding different kinds of profits? If I have money to deposit in my bank account, that’s good enough for me!”
Money in the bank is definitely a goal. But you’ll thank yourself (and likely be able to put even more money in the bank) once you can easily see the importance of Gross Profits and Net Profits.
What are Gross Profits?
Gross Profits are what you get when you subtract your variable expenses (a.k.a. “Cost of Goods Sold” or COGS) from your total revenue. This is figured up for each individual item you sell (or service you provide). The per-item result varies because the factors that go into each individual item isn’t the same.
Gross profits are typically expressed as a percentage in order to make it easier to compare the profitability of various items at a glance. For example, if total sales of an item were $1,000,000 and you had $250,000 left over after the direct costs of that item, you’d have a 25% gross profit on that item.
Knowing this number for each item or “thing” you sell is important because it helps you see what product or services are generating the most gross profit
Let’s say you’re a restaurant owner. Your typical overall gross profit percentage is is somewhere around 30-40%, so every dollar counts. You really need to know what the gross profit margin is for each item on your menu. That way you’ll know which items to promote because they’re your best performers. (I’m looking at you, soft drinks!)
FYI: A common myth in the restaurant industry is that keeping food costs low leads to higher profit margins. Saving money is always a good idea. However, the National Restaurant Association agrees with me its not the food costs independently that you should be managing, but rather what are the absolute gross profit dollars that that item generates.
Ok, so what are Net Profits then?
When you total up all of your gross profits then further subtract your fixed operating expenses, you get your Net Profits. This is a single total total that reflects the profitability of your entire business.
Here’s another way to easily remember it all
- Gross profits are how much money is left over after you’ve made your product/service.
- Net profits are how much money your business actually made after everything else not directly related to making your product or service.
Real-world Example Again
Last week, your restaurant brought in total revenue of $18,000 (including all food, wine, and drink sales).
Your total COGS were $6,000, making your Gross Profit = $12,000. (You would have broken it down to identifying your profit margin for each menu item, plus your direct production labor for both front of house and back of house staff but for the sake of time we’ve skipped that here.)
Now, to determine your Net Profit you’ll subtract:
- Manager labor: $3,500
- Rent: $700
- Utilities: $400
- Property Tax: $130
- Insurance: $150
- Miscellaneous: $200
…which brings your Net Profit to: $6920. Cha-ching.
So now that you’re a pro on Gross vs. Net Profits, find out what other accounting topics we can help you crush. Check us out at patrickaccounting.com or give us a call at 901-755-5858 (in Memphis) or 501-834-5757 (in Little Rock) to set up your 1-hour introductory meeting!