Most businesses exist to make money and being able to calculate and interpret
the net profit and gross profit margins of a business is key to measuring a
business's performance, so let's take a look at how to do this.
One of the most important financial concepts in business is gross profit,
this is a difference between sales revenue and the cost of goods sold, it is
calculated by subtracting the cost of goods sold from sales revenue.
Effectively it's the profit a business makes after deducting the costs which
are associated with making and selling its products or the cost associated with
providing its services. The cost of goods sold refers to the direct costs of
producing the goods sold by the business which includes the cost of materials
and the labor which is used to create the goods. However, it's important to note that the
gross profit only includes variable costs to assess the business's efficiency in
using its labor and materials when producing goods or services, it does not
include a business's fixed costs, if you'd like to know more about the
difference between variable and fixed costs then you could watch our video on
this subject a link will be made available at the end of this video. The
gross profit of a business essentially shows how good they are at producing
products or services at cost-effective price and how accurately they can price
their products to maintain a high volume of sales with the highest possible
margin. Essentially the higher the gross profit, the better it is for the business.
So let's take a look at calculating the gross profit, now the figures of business
requires to calculate their gross profit can all be found on their income
statement. Firstly, we start with the sales revenue which in this example is
two hundred and fifty thousand pound, we then deduct the cost of sales which in
this example is a hundred thousand pounds, this leaves us with one hundred
and fifty thousand pounds this is our gross profit figure. Once the businesses has
calculated its gross profit it can now work out its gross profit margin which is
always shown as a percentage. the gross profit margin is calculated by dividing
the gross profit by the businesses sales revenue and then multiplying the answer
you get by 100. So if we use the figures taken from the previous example this
would mean we would start with the gross profit of one hundred and fifty thousand
we would then divide this by the sales revenue of two hundred and fifty
thousand. This gives us an answer of zero point six, now it's very important to
remember to multiply this answer by 100 to turn it into a percentage which in
this example gives us 60, this is the gross profit margin, so 60%
of this business' sales revenue is gross profit. What's classified as a good
gross profit margin will vary dependent on the business and the industry it
operates within. So let's have a look at how to interpret the gross profit of a
business, put simply, businesses want to see their gross profit and gross profit
margin increase year-on-year, the higher it is, the better for the business one
key way to assess gross profit is to compare it with competitors if this
information is available, another way is to compare the gross profit margin
against previous years to see if it is increasing or decreasing.
if the business's gross profit margin is decreasing year-on-year then this must
be investigated by the managers and owners of the business to resolve the
issue as soon as possible if this was the case and the owners wanted to
investigate a change in the gross profit they would typically consider a few key
factors to begin with. One reason for a change in the gross profit could be
linked to the cost of sales if this figure was to go all for example the
materials for producing a product or the labor pay per hour increased but the
selling price stayed the same then the gross profit of the business would
decrease. A second key reason for a change in a business's gross profit is a
price at which products are being sold, if the business's products are now being
sold at a lower price and the variable costs remain the same, this will
ultimately decrease the growth profit for the business. Once the business has
investigated and found the reasons for the change in gross profit it can
implement change, for example increase incresing the selling price or seeking to find
cheaper suppliers. So now we're going to move on to net profit, this is sometimes
referred to as the bottom line, it is the amount of money that the business is
left with after they subtract their total business expenses from their total
revenue, as you can see from the formulas on your screen now however a business'
net profit doesn't include any tax payments as the tax the business pays is
actually based on their net profit figure, therefore you may also see this
called net profit before tax. The net profit
figure appears at the bottom of the statement of financial position,
therefore the total business expenses include the cost of sales figure used in
the gross profit calculation but also includes all other costs
such as the operating expenses and all of our overheads that are incurred by
the business such as rent and interest on loans. Therefore, the net profit will
always be lower than the gross profit. The higher the net profit margin, the
better it is for the business as this shows how profitable the business is
overall, a key measure for any business and something that stakeholders will be
interested in. So let's take a look at calculating the net profit, same as the
gross profit the figures the business requires to calculate their net profit
can all be found on their income statement. Firstly we start with the
sales revenue which in this example is two hundred and fifty thousand pound we
then deduct the total business expenses which in this example is two hundred and
twenty thousand pound, this leaves us with thirty thousand pound, this is our
net profit. Once the business has calculated its net profit it can now
work out its net profit margin which is shown as a percentage in the same way
that the gross profit margin is shown as a percentage. The net profit margin is
calculated by dividing the net profit of the business by their sales revenue and
then multiplying the answer by 100 as shown by the formula on your screen
right now so if we use the figures taken from the previous example this would
require us to start with a net profit of thirty thousand pound we would then
divide this by the sales revenue which is two hundred and fifty thousand pound
and this will give us an answer of 0.12 now it's very important to remember to
multiply the answer by 100 which in this example gives us 12 this is your net
profit margin remember it's shown as a percentage so
it's 12 percent. Just like gross profit to interpret the net profit a business
will typically do one of two things, they can compare their net profit to their
competitors or compare their net profit against their previous year's
performance. By improving the gross profit figure the net profit figure will
naturally increase and a key point to acknowledge is that the net profit will
always be lower than the gross profit this is because it is at the bottom of
the business's income statement and therefore has to also deduct the
operating costs and overheads from their sales revenue. However, in this example
our net profit is much lower than our gross profit, the gross profit for the
business was was a hundred and fifty thousand
pound, giving us a gross profit margin of 60 percent however the net profit was
only thirty thousand which gave us just a 12% net profit margin meaning for
every 1 pound of income only 12 P is net profit . Therefore, it is clear to see in
this example that the business needs to reduce its operating costs and overheads
so the owners of management team should investigate costs such as rent, insurance
and salaries to see if there is any opportunity to reduce these costs
further and if they were successful in doing this, this would ultimately
increase the business's net profit. Thank you for listening I hope that helps you
to understand how to calculate both gross and net profit and the differences
between them as well as being able to interpret both of them and what it means
for a business this should help you make better financial decisions and if you
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