No matter the size of your business, it is important to assess its performance. This can be most clearly understood by calculating profit.
Often, small businesses are conceived due to a passion for a product or service, but regardless of this – all businesses need a profit to be successful.
This guide will help you get your head around some of the technical terms when it comes to calculating profit.
Why Calculating Profit is Important
Looking at profits and losses is one of the main ways to analyse a business’s stability. It can often get confusing looking at these figures, especially if you’re new to owning a business. When looking at your sales information, it is not always clear how much profit your business is actually making. To tackle this, you should calculate profit over a set period.
It’s common for owners to look at their management information and if it appears lots of sales are being made, the owner will be pleased but may be unknowingly financially struggling.
It is only once you calculate profit, not just focus on the number of sales, is when you will see your business’s true financial health.
This is an effective way to see if you need to tighten up areas where you’re currently spending too much, such as inefficient packaging or transport costs.
Another key reason to calculate profit is if you have plans for expansion. Without a sizable profit, you will struggle to execute your plans.
Gross Profit Vs. Net Profit
It’s important to understand the difference between these terms before you can begin calculating profit, otherwise your figures will be skewed and you may encounter financial trouble.
- gross profit: this is your total sales minus your direct costs (direct costs are the costs of making your product or selling your service. Including: cost of materials, transportation, & wages)
- net profit: this is the total after you’ve subtracted operational expenses, such as rent, insurance, and sometimes even taxes
Using the following formula, you can calculate both your gross and net profit:
Gross profit = sales - direct cost of sales
Net profit = sales - (direct cost of sales + operating expenses)
What About Profit Margin?
Profit margin is essentially what you have just calculated through the above formula. The slight difference is that the profit margin is presented as a percentage, rather than a figure in pounds. Having this information presented as a percentage makes it easier to understand your business’s continual performance, as well as comparing it to other businesses.
The following formulas can be used to calculate your gross profit margin and net profit margin as percentages:
Gross profit margin = (gross profit/ sales) x 100
Net profit margin = (net profit/ sales) x 100
For every business, the profit margin will be different, as will the goals you have – so don’t be under the impression there’s a certain percentage that means your business is successful. It depends on what your overall business trajectory and goals are.
Also remember, if you do want to use profit margins to compare your business to others, use a business with similar characteristics to yours. This is because all businesses are different sizes and have different objectives.
Profit margin isn’t the only figure to assess when doing a check-up on your business’s health. You should also look at your cash flow and turnover to get an overarching view.
Improving Your Profit Margin
Once you have calculated your profit margins, you may want to look into how to increase profitability. Again, techniques for each business will differ according to its needs.
Below we have highlighted a few areas you may want to explore:
- increase productivity – Think about processes you could make more efficient? Think about using time and project management tools to boost your employees’ (and your own) productivity, meaning there’s more time for tasks that need attention
- increase turnover – Think about the customers you already have; how can you increase sales to them? Try up-selling or cross-selling goods & services
- reduce costs – This is a commonplace business owners focus on to increase profit. It’s quite simple too, i.e., ensuring you’re on the most efficient energy tariffs and best value bank accounts. If you’re not, contact the companies you’re with and discuss rates
There you have it – a short and simple guide on how to calculate profit.
It’s worth spending time on the figures here as they can ultimately help with your overall business objectives. These figures are also necessary to produce if you want to sell your business.
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