Profit 101 - Understanding How to Calculate Profit and Improve Gross Profit Margin

Profit is an indicator of business success. All business owners need to understand how to calculate profit. Businesses are not sustainable without earning profit. Small business owners are susceptible to changes in their products, customers, competition and markets; and that susceptibility impacts profits.

(Side note: Small business owners need to ensure that they set up their books properly. Get solid accounting and financial advice as you startup your business.)

First, it is important to understand how to calculate profit. The profit equation is Total Revenue minus Total Expenses equals Profit. The definition of total revenue in this article includes income from sales and business operations, investment income and other revenue sources. The definition of total expenses includes costs such as your utilities, rent, labor, materials, transportation, insurance, marketing costs, supplies, taxes, debt interest, and other costs incurred by operating your business. The profit (or loss) is the amount that is left over after you subtract total expenses from total revenue during a defined period.

Understanding your profit and how revenue and expenses impact your profit calculation is the first step in becoming a profit-driven business (there are other drivers that should also be important to your business: customers, employees, suppliers, quality, service, and more). Part of your growth strategy needs to target acceptable (or better) profit goals and needs to identify how you will achieve those goals (sell more, cut costs, diversify, etc.).

For example, if your business sold $400,000 worth of products and your all-in expenses (including your salary) for providing those services totaled $360,000, then you would have earned a $40,000 profit or 10 per cent. That would be a very respectable profit for a young business (actually in today's business climate that would be a respectable profit for any business).

During the 1990s, my clients targeted 18 per cent as a reasonable profit goal; today many of those clients would gladly accept an 8 per cent profit. The economy and the financial markets are factors that are not within our control; but what is within our control is how we react, pro-act and manage our businesses during these challenging times. Your business sustainability is dependent on producing reasonable profits. It is important that you plan to be profitable and then execute your plan. But plan for a reasonable profit. Some small business clients I have worked with have forecast impossible-to-achieve sales revenues; and impossible-to-achieve profits. Then, when they don't achieve either, they are disappointed and discouraged. Be realistic. Understand your market, your costs, your potential sales; then plan for an achievable profit.

Once you have calculated your profit goals and put your small business plan into place to achieve those goals, turn your focus on understanding and managing your gross profit margin. Gross profit margin is net sales revenue minus cost of goods sold (COGS) - not including your administration expenses and selling expenses, and then divided by net sales revenue. (In a merchandising operation, COGS includes beginning inventory, plus inventory purchases, minus ending inventory.) Your gross profit margin targets range within industry: typically from a high of 70 per cent (highly automated manufacturing plants) to a low of 30 per cent (highly manual operations). So find out what your industry average is: talk to lending institutions - they often have that data or talk to your industry association - they can often find out that information.

Ensure that you target a better than average gross profit margin and then organize your business to achieve it (by increasing sales, adding new products or services, diversifying, aligning with other providers, decreasing costs, and other options). If you focus on achieving a good gross profit margin for your business, your business will be on solid financial ground.

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