Mind Your Own Business Through Gross Profit and Net Profit
by DR. CHRIS ARDUESER, MBA, DBA
One of the fundamentals that will keep a business competitive is knowing the standards in your industry. This awareness will help you identify areas of weaknesses, recognize your company’s strengths, and take notice of any potential opportunities the company may have. It is important to know what industry standards you need to keep up with, and where you need to focus your energy so you can remain competitive. There are many areas of business on which one can focus, and each one will provide different insights and give you something to measure against. Having something to measure against gives you a standard to which your company can be compared.
Two such standards are gross and net profits. These industry standards inform decision-makers whether their company is doing ok and meeting the norm for that industry. This can be especially important for small businesses because they need to know if they are making the money they are supposed to make, and also if they are staying competitive within their industry.
The gross profit, or gross margin, is the remaining money from the total sales revenue after subtracting the costs of goods sold (COGS). The COGS are just that, the cost of what it takes to make your products or provide your service. The COGS typically includes the materials and labor it takes to make the final product.
The word gross tells us that no other expenses have been taken from the total revenue at this time and lets you know what is left over to pay additional costs. The gross profit does not directly tell you your overall profit, but is a significant number to examine and compare to industry standards. We suggest that you segment out your COGS to get a better set of numbers to analyze, and look at it as percentages of total revenue.
Comparing this number to industry standards is very important. It can tell you if you are competitively priced. It can reveal if you are paying too much for the raw material and expose your levels of waste from the raw material and labor. Understanding this can inform you of how efficient you are in making your product.
Looking at your profit and loss statement (P&L) can tell you if you are sitting on too much inventory. It can help you recognize if you have a poor turnover, or bad purchasing patterns. P&L does not account for inventory on hand. Having high inventory means having money on the shelf, lowering your cash flow, and limiting other opportunities where that money can be doing something else or making you more money.
The gross margin’s nature allows an owner to see how well they are doing operationally, compared to an industry standard, and where they need to focus efforts in the operations to be better and more profitable.
The net profit is the bottom line, or the company’s money when all expenses have subtracted from the total revenue. This needs to include the owner’s pay if you are a sole proprietor. When it comes to industry standards, understand that not all data takes the owner’s salary into account and therefore can gives some skewed results. However, it still provides you with a percentage you can use to compare and make decisions.
Here at AGDA (www.agdaconsulting.com), we typically advise that net profits be as low as possible after knowing a company is meeting the industry standards. This means that the company is investing money in itself to better the company. That is why it is key to be competitive with industry standards.
Low net profit tells you that the company is making the money that is needed and that it can also do other things. A company’s net profits are what is left over. That money can be used to expand your company, or reinvested back into the company to make the company, product, experience, or presence better. It can also be kept on hand for additional opportunities.
If a company’s net profit is below the industry standards and all other areas are in line, it tells us that sales levels are typically not sufficient. Then leadership can follow up by increasing sales or investigating why the sales are not enough. It can also tell us that costs between gross and net profits are too high or not in line with current norms. Every situation is different, but it is important to compare to the industry standard to see if your business is sustainable, and if line items are appropriate.
Remember that meeting industry standards is simply a way to measure your business against others within your industry. If your business is operating within the industry norm, you are performing at an average level. These performance numbers can change with innovation and markets. If you can find ways to implement innovation, you can increase your gross profits! When Ford introduced the assembly line, the innovation increased production time and lowered labor costs, giving a better gross profit and allowing the company to have more opportunities with the remaining cash.
If the cost of a product goes up, but a market does not allow for the sale price to match, there will be loss. If revenue decreases due to an economic situation, and a business does not adapt to meet the industry standard, both the gross profits and net profits will decrease.
Company leaders who know their industry standards, and can meet them, can then make better decisions more quickly, and stay ahead of situations that can cause loss. They can also find ways to make their company more profitable, whether through reinvestment or increased cash on hand to be used and distributed as the company deems appropriate. Most importantly, informed company leaders know that they will have the profit the company needs to continue serving customers.