Introduction: Due to the tough job market these days, many people are considering starting what will be their first business. This article falls into what I call “business 101″. It aims to help budding entrepreneurs avoid some of the mistakes that are so common to startups.
The previous article highlights the importance of understanding the difference between margin and markup. The article ended by saying that there was another critical point to consider, namely, the difference between Gross Profit and Net Profit.
This is a very important point and you must be intimately familiar with it!
Gross Profit is the total amount of profit made from your sales. It is your total revenues minus your total cost of goods sold. It does not factor any other expenses such as your cost of doing business.
Net Profit is your gross profit minus all operating expenses. This is your bottom line!
Gross Profit Margin is your gross profit expressed as a percentage of your total revenues.
Net Profit Margin is your net profit expressed as a percentage of your total revenues.
Expanding on the scenarios we used in “The difference between Margin and Markup”, I will present a few examples that should clarify this for you. Familiarize yourself with the spreadsheets, as I will use them in future articles.
Review the following carefully. It is broken down into sales, profits and basic expenses. The bottom line reveals the net profit and net profit margin. It is from the bottom line that you will pay yourself. The first scenario assumes sales of 50 units at a selling price of $1,500.00 each with a cost per item of $1,000.00. As we covered in the previous article, this selling price is a 50% markup over the cost.
This is a nice result. You have $9,400.00 left over from which you can pay yourself. Notice the difference between Gross Profit Margin and Net Profit Margin. When someone tells you that their business enjoys a 20% Profit Margin, ask them if they mean gross or net. As you can see, there is an enormous difference between the two. A 20% Gross Profit Margin would result in a $1,850.00 loss in the example above. I did the math 😉
Now, let’s paint a different scenario. You have gone on holidays for a month (lucky you!) and your sales manager has decided to run a sale. He or she incorrectly believes that a 50% markup means a 50% profit. They believe that by offering a 25% discount, they will double sales and you will be thrilled on your return.
The results of the first scenario remain on the spreadsheet for comparison.
Well, your unit sales doubled and your revenue is higher. Your sales manager is ecstatic and believes you will be as well. Also, the sales manager will get a bigger commission check.
Only problem is, you lost $7,350.00. Actually, it’s worse than that. Had the sales manager maintained sales of 50 units at the regular selling price, you would have made $9,400.00. That’s called ‘lost opportunity cost’ by the way. The delta between the two numbers is $16,750.00! That holiday turned out to be quite expensive. Now you fully understand the sad face in the last article.
It is imperative to know the difference between markup and margin, net profit and gross profit. You need to be totally in touch with these details, as do all of your employees who have the ability to adjust pricing.
I hope these two articles have been helpful and that you have understood them. If not, re-read them or print them off and discuss them with an accountant or an experience businessperson who fully understands these concepts.
I would also suggest that you read the following two articles:
The mixed blessings of corporate metrics
While more philosophical, they present ideas that could help you avoid many pitfalls and perhaps even spark your imagination.
Good luck and good selling!
Comments are open on this article
© Gil Namur, 2009
Your example is excellent and give the clear view of the topic.
Mr gill sir you example is outstanding. Its perfect and Ive completely understood the whole thing as all these terms have been bothering me for quite a while. Thank you sir keep up the good work.
Hi ABBASI,
Thanks for your feedback and you kind words. I am happy it helped!
Have a great weekend.
Cheers,
Gil
Great example really these two terms are quite confusing glad yuve helped. Thanxx
Hi,
I just wanted to know how the loss of $1,850 was worked out on 20% Gross Profit Margin in your example 1 above.
My calculation gives a different figure: 20% Gross Profit (of $75,000) = $15,000 – $15,600 (total expenses) = $600 LOSS.
Could you please explain how did you workout the loss figure of $1,850. Thank you.
Hi T!
Thanks for your question.
Ok so. The confusion comes from this.
You say 20% GP of 75000.00 = 1500.00
(75,000.00 X 20%)
Or – your revenue (75,000) X 20%
This is a ‘markup’ calculation, not a margin calculation. Margin is what you need to use.
However, your math is correct if you use a 20% markup, here are the results.
(sorry for the weird formatting .. I am unable to insert nicely formatted tables here)
Sales (Revenue) Month
Quantity Sold 50
Selling Price $1,500.00
Total Sales (Revenue) $75,000.00
Gross Profit
Cost of goods per unit $1,200.00
Total cost of goods sold $60,000.00
Gross Profit $15,000.00
Gross Profit Margin 20.00%
Expenses
Facilities Cost $2,000.00
Phone Bill $300.00
Hydro Bill $200.00
Insurance Costs $100.00
Shipping Fees $500.00
Commissions Paid (10%) $7,500.00
Staff Salary $5,000.00
Total Expenses $15,600.00
Net Profit $600.00
Net Profit Margin -0.80%
Now look at this example (below) which is the math I used.
Both are correct. They are simply applying different calculations to different sides of the ledger.
Hope this makes sense 🙂
Cheers,
Gil
P.S. Also be sure to read – http://www.synaptici.com/2009/the-difference-between-margin-and-markup/
Sales (Revenue) Month
Quantity Sold 50
Selling Price $1,250.00
Total Sales (Revenue) $62,500.00
Gross Profit
Cost of goods per unit $1,000.00
Total cost of goods sold $50,000.00
Gross Profit $12,500.00
Gross Profit Margin 20.00%
Expenses
Facilities Cost $2,000.00
Phone Bill $300.00
Hydro Bill $200.00
Insurance Costs $100.00
Shipping Fees $500.00
Commissions Paid (10%) $6,250.00
Staff Salary $5,000.00
Total Expenses $14,350.00
Net Profit $1,850.00
Net Profit Margin -2.96%
Hi Gil,
thank you for your response of March 8, 2010 at 10:03 am to my earlier query of the same date.
is it correct to assume that both of the Net Profit figures in your response calculations are LOSSES?
Net Profit $600.00 is this a Net Profit figure a LOSS?
Net Profit Margin -0.80%
and
Net Profit $1,850.00 is this Net Profit figure, also a LOSS?
Net Profit Margin -2.96%
Thank you,
Tariq
Hi Tariq,
Indeed, in ‘those’ examples, they are both losses.
Cheers,
Gil
Very simple and lucid explanation, special thanks for detailed illustration of the example as well in comments.
Thanks Santosh 🙂