Gross, Operational and Net Profit (Differences)
The word ‘Profit’ is used loosely in the business world. Profit refers to the amount earned net of costs in a transaction. The key is defining a transaction. There is the direct transaction whereby a customer purchases a product and so it is simple math; sales value less cost of item sold equals profit. Then there is the cost of selling large quantities of goods to various customers like a retail store. Now additional costs come into play including staging the products, labor to process the sales and answer customer questions, marketing to get the customer there etc. Finally there is the profit earned after taking into consideration other indirect costs such as back office operations, cost of capital and taxes.
In effect the term profit changes names as it becomes more inclusive of additional costs. The profit earned after every single cost is considered is called ‘Net Profit’. Net profit refers to the final amount of business earnings available for transfer to owners.
Each of the following sections explain the one of the various terms of ‘Profit’ from the most exclusive to the variant that includes every revenue and cost possible.
Gross Profit
The most simplistic definition of gross profit is a sale less cost of product sold or service rendered. A good example is the lawn maintenance guy. He charges by the yard. If the fee for service is $50 and he pays his laborer $9 for that one hour of service, the gross profit is $41. Is it this simple? No, it is actually a little more complex than this.
The laborer used the following tools and supplies:
– Zero turn lawnmower
– Weed eater
– Some of the line spool in the weed eater head
– Gasoline
– Gas/Oil mixture for the weed eater
– Leaf blower
– Trash bag
– Broom
Notice now it really is not as simple as it initially appears. The problem with this is that all these costs are spread over several jobs that day. Maybe $1.50 of the fuel was used for this particular job but unless the owner measures it out precisely he’ll never know.
To complicate this even more, how do you incorporate other indirectly related costs including?
– Transportation to the job site
– Trailer costs to haul the equipment
– Insurance including worker’s compensation
– Employer’s payroll taxes
The answer lies in defining costs associated with the respective sale. There are two types of costs related to the actual sale process.
Direct Costs
Direct costs are sometimes referred to as prime costs. It means those costs that are undeniably associated with the sale of the product or service. The most common direct costs include materials and labor. Sometimes it is difficult to definitively state that a particular cost is directly attributable to that sales of a unit. Labor is a good example.
* A dealership sells a car, therefore the cost of the car is a prime cost. The salesman’s commission is also a prime cost. However, is the labor of the lot attendant (washes the cars) directly attributable to the sale of this particular car? No.
* When dealing with a group of homogeneous items sold to various customers like retail, auto repair, restaurants or personal care the various labors of the clerks are direct costs.
The key is that direct costs physically handle the items sold or services rendered in some form. Direct cost broadens as the subject of the sale moves from a single item to multiple similar items.
Indirect Costs
Indirect costs consist of expenditures necessary to complete the sale but can not be directly assignable to a particular unit or units of sale or service(s) rendered. These costs are spread over two or more units and in general are not involved in directly handling the items sold. But these costs are necessary to facilitate the sales on a day-to-day basis. Examples include production management, store manager, shipping/receiving, packaging, marketing etc.
Go back to the lawn maintenance example above; those costs not directly identifiable to the job are indirect costs.
Gross profit is simply sales minus direct and indirect costs for the item and/or service sold. These costs include materials, labor, transportation (shipping/receiving) and costs to make the item ready for sale. Different industries calculate and present the gross profit in different ways. The following are some examples:
RETAIL
Sales $ZZZ,ZZZ
Cost of Goods Sold:
Product $ZZ,ZZZ
Retail Labor Z,ZZZ
Shipping/Receiving Z,ZZZ
Supplies ZZZ
Sub-Total Cost of Goods Sold ZZ,ZZZ
Gross Profit $ZZ,ZZZ
SERVICE
Sales $ZZZ,ZZZ
Cost of Services Rendered:
Professional Staff $ZZZ,ZZZ
Outside Consulting ZZ,ZZZ
Reimbursements Z,ZZZ
Technology Z,ZZZ
Sub-Total Cost of Services Rendered ZZZ,ZZZ
Gross Profit $ZZ,ZZZ
CONSTRUCTION INDUSTRY
Contract Income % of Completion Method $Z,ZZZ,ZZZ
Direct Costs of Construction
Materials $ZZZ,ZZZ
Labor ZZZ,ZZZ
Sub-Contractors ZZZ,ZZZ
Other ZZ,ZZZ
Sub-Total Direct Costs of Construction ZZZ,ZZZ
Direct Margin ZZZ,ZZZ
Indirect Costs of Construction
Management $ZZZ,ZZZ
Transportation ZZ,ZZZ
Communication ZZ,ZZZ
Insurance ZZ,ZZZ
Equipment ZZ,ZZZ
Sub-Total Indirect Costs of Construction ZZZ,ZZZ
Gross Profit $ZZ,ZZZ
Notice the difference between the three different reporting formats? The construction format is driven by direct and indirect costs of actual construction. All of these costs in all three formats are incurred before office and general expenses.
One last note concerning the term ‘Direct Margin’. Sometimes it is called ‘Direct Profit’. This is another variance of the term ‘Profit’.
The next step in calculating the final net profit is to the determine operational profit.
Operational Profit
From gross profit is subtracted front and back office expenses. In business this commonly referred to as general and administrative (G&A) or overhead expenses. As accountants we call them expenses. In general expenses are grouped into six major sets:
* Management – front and back office payroll including any outside consultants (accounting and legal), benefits; production management is a function of gross profit and is included in cost of sales.
* Facilities – rent, utilities, real estate taxes, repairs and maintenance
* Communications – telephone, cell phones, internet, cable and radios
* Insurance – general liability, property, professional, umbrella, life
* Office – office supplies, postage, technology, training, meals and entertainment
* Taxes and Licenses – revenue, personal and business property; certification, continuing education, franchise license, assessments
Expenses generally have very little to do with the day-to-day sales of products or rendering services. These costs are long-term in nature and are required to run the business but not sell the product.
Notice how operational profit is more inclusive of other generic expenses. There is another term often substituted for operational profit and it is called Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The taxes refers to income taxes and not the group of taxes found within the expenses as identified above.
The following is an example of a profit and loss statement through the operational profit line.
Revenue:
Sales $ZZ,ZZZ
Adjustments (ZZZ)
Net Sales ZZ,ZZZ
Other Revenue Z,ZZZ
Total Revenue $ZZ,ZZZ
Cost of Goods Sold:
Product $ZZ,ZZZ
Labor Z,ZZZ
Shipping ZZZ
Supplies ZZZ
Sub-Total Cost of Goods Sold ZZ,ZZZ
Gross Profit ZZ,ZZZ
Expenses:
Management $ZZ,ZZZ
Facilities Z,ZZZ
Insurance Z,ZZZ
Office Z,ZZZ
Taxes & Licenses Z,ZZZ
Communications ZZZ
Sub-Total Expenses ZZ,ZZZ
Operational Profit $Z,ZZZ
The reader should see a pattern develop. Each variance of profit increasingly gets more inclusive of costs. Gross profit is the least inclusive because it is limited to direct costs associated to what the customer purchased. Operational profit is more refined because it includes general operational costs (expenses). To further clarify profit, capital costs must be subtracted to get profit.
Profit
Operational profit or EBITDA doesn’t include depreciation , amortization or interest. These three expenses are a function of capital financing. The purchase of fixed and intangible assets are depreciated and amortized over time. Most of these assets are financed and the interest to service that debt is also a capital cost. From operational profit capital costs are subtracted and the business has its profit, not net profit, but profit. Three are still three more sets of costs a business may incur to get the final net profit.
Net Profit
Net profit is defined as the final amount of earnings that are available for payment to owners. There are no other obligations. Between profit and net profit exists three distinct groups of monetary transactions.
1) Unusual Events – ordinary transactions that either generate costs or create additional revenue. This includes insurance proceeds and costs associated with that event, sale of equipment, write-down of value for intangible assets and so on.
2) Extraordinary these are unusual and infrequent events causing a significant change in value for the business. Examples include a major lawsuit (gain or damages), sale of a division or any event that is rare.
3) Income Taxes – some small businesses do not pay income taxes due to their legal standing with the IRS (S-Corporations, Partnerships and Limited Liability Companies).
Now let’s take a look at a full income statement identifying the various points of profit.
GOLD NUGGET MINING INC.
Income Statement
Year Ending December 31, 2015
Revenue $1,318,205
Co-Share Rights (131,821)
Net Revenue 1,186,384
Costs of Mining:
Labor Cuts (Shares) $394,202
Fuel 410,610
Equipment 108,918
Safety 3,401
Licenses (Mining) 7,012
Sub-Total Costs of Mining 924,143
Gross Profit 262,241
Expenses:
Management $107,000
Transportation 19,402
Lodging/Camp 13,212
Leases 6,010
Office 3,401
Professional Fees 10,619
Insurance 12,621
Taxes & Licenses 7,402
Sub-Total Expenses 179,667
Operational Profit 82,574
Costs of Capital:
Interest $41,202
Depreciation 13,181
Depletion 17,402
Sub-Total Costs of Cap 71,785
Profit 10,789
Add: Gain on Sale of D-9 (Dozier) 9,402
Less: Income Taxes (Income/Capital Gains) 6,018
Net Profit $14,173
Summary – Gross, Operational and Net Profit
The term profit must be qualified to identify the particular point in the income statement (profit and loss statement). There are four well accepted variances of the term profit.
Gross Profit – most restrictive in that it pertains to value earned off the sale of products or services to customers.
Operational Profit– a profit more encompassing as it is inclusive of general expenses.
Profit – after operational profit but includes capital costs such as depreciation, amortization and interest.
Net Profit – the final amount available to investors after including unusual, extraordinary events and income taxes.
As a business entrepreneur understanding these various forms of profit (qualified terms of profit) elevates your understanding of business terminology from the novice level to the more sophisticated position. ACT ON KNOWLEDGE.
Value Investing
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There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
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- Patience – Allow time to work for the investor.
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