Profit: It’s the reason every entrepreneur hangs her shingle and goes into business. While profit is the most basic drive for any business, many small entrepreneurs don’t understand the finer points of profits, profit margins and how both impact their business plans. While profits measured in dollar values and profit margins are two very different measures of an entrepreneur’s success, small business owners must understand what each represents and how it impacts the health of their business.
Businesses frequently use a couple of means to measure their profit in dollar values. The most simple is gross profit, which represents the difference between sales and the cost of the materials needed to create the goods. Net profit, which is also measured in dollars, represents the difference between the sale price and the cost of its creation, as well as variable costs, such as labor, taxes, rent and other indirect business expenses. Both net and gross profit represent a dollar amount a business receives with each transaction, and can be the basis of basic financial planning as well as a broad estimate of a company’s performance.
Profit margins represent how much money a company makes based on its expenditures. Expressed as a percentage, business owners calculate gross profit margins by dividing gross profit by sales. For example, the gross profit on a chair that costs $65 to manufacture and sells for $80 is $15. Its profit margin is 18.75 percent, or $15 divided by $80. Because variable costs are difficult to assign on a per-item basis, net margins are best used to determine the margin on an entire business or division, rather than single sales calculations.
Another tool entrepreneurs can use to evaluate the success of their sales efforts is markup percentage. Markup pricing divides the gross profit by total costs. For example, the markup on the chair that costs $65 to manufacture and sells for $80 is about 23 percent, or $15 divided by $65. While this also measures the portion of receipts that are profits, its methodology is different than that of gross margin, so the terms shouldn’t be used interchangeably.
Most businesspeople monitor their margins as much as their overall profits, as margins represent how efficiently a company produces its profits, and is a better measure of a company’s performance than overall profit levels. For example, a company could maintain gross profits of $1 million each year, while its gross margin decreases from 12.2 percent to 11.3 percent over three years, indicating the company is expending more resources to generate the same amount of profit and is, therefore, losing ground.
