Are you sure you understand the difference between gross and net profit, and how to calculate your profit margins? It’s surprising how many business owners are vague about this. In a small business you may trust your accounts staff to give you the figures and reports you need, whether or not they are deserving of your trust. In a micro business, you may not have the staff to deal with these aspects.
Your profit margins are a key indicator of the health of your business. You need to know what they are, if they are changing and why. If your profit margin is going up, you can’t afford just to sit back and congratulate yourself. The rise could be temporary and the fall that follows could be a serious crash. You need to recognise the reasons for the rise to predict what will happen next, and to learn the lessons that might help you to keep it high or repeat the momentum. If the margin is going down, you must understand the reason so that you can do something about it.
Gross Profit or Net Profit
Gross profit is the amount of income you receive from a product or service, less the amount it costs you to provide it. Knowing or predicting your gross profit helps you to decide what products and services to supply.
To arrive at your net profit, you have to add all your overheads into the equation. For interested parties, such as lenders, your net profit is what counts. It should also be the most important to you because, even if you are getting a good gross profit margin, if other expenses are too high, the net margin can still be very low.
The Profit Margins
It’s easy to arrive at your gross profit margin. You divide your gross profit per item by its sale price and multiply that by 100. That gives you your margin as a percentage figure.
To arrive at your net profit margin is a lot more complicated, because you have to get your overhead figures right. They might include wages and salaries; the expenses relating to your premises; equipment; travel and communication costs, and so on. You’ll have to average them out to monthly, weekly, daily, or whatever period you choose to check your net profit margin. A similar calculation takes that into account as well as your total sales for the period and the direct costs of producing them.
Whether you do it yourself, or get these figures from staff or outsourced bookkeepers, to have real confidence in the health of your business, it’s best to have a good understanding of where the figures are coming from.