What is the difference between gross and operating profit?

November 11th, 2013

When faced with poor financial performance many business owners try to increase their turnover to solve their bottom line problems. However, it is a misconception to consider turnover to be a measure of the business income. The real income of a business is the gross profit.

Before calculating profit values and taking steps to improve your business profitability, first let us baseline the terms used and what they mean.

Direct and Indirect Expenses

Understanding direct and indirect expenses is the key to recognising the difference between gross profit and operating profit:

  • Direct expenses are those incurred as part of the process of earning the revenue. These expenses are directly proportional to sales. For example, the cost of materials is a direct expense. If a widget costs $2 each and you sell 1 widget the direct expense for the material is $2; if you sell 5 widgets the direct expense for the material is $10. Direct expenses include:
    • The cost of materials that are sold, or are used to make a product that is sold
    • The cost of labour to manufacture the product or deliver a service
  • Indirect expenses are those that your business incurs irrespective of whether you sell 1 widget or 5. Indirect expenses include:
    • The cost of owning or leasing premises for your business
    • The cost of services and utilities
    • The cost of labour that is employed in your business but is not used to directly earn revenue from sales, for example office and accounts personnel, management

Gross Profit

Gross profit is the revenue from sales less the cost of goods or services sold. Gross profit is calculated as follows:

Revenue from sales $1,000,000
Less Direct Expenses $455,000
Gross Profit $545,000

Gross profit is sometimes also called gross profit margin or simply margin. Gross profit may also be presented as a percentage value. Gross profit percentage is calculated by dividing the gross profit $ by the revenue from sales $. In the example above the gross profit percentage is 54%.

Operating Profit

Operating profit is the balance remaining of revenue from sales less the direct and indirect expenses. Put another way, operating profit is the gross profit less the indirect expenses. Operating profit is calculated as follows:

Gross profit $545,000
Less IndirectExpenses $235,000
Operating Profit $310,000

Operating profit is often referred to a net profit because it is net of all expenses, both direct and indirect. Operating profit may also be presented as a percentage value. Operating profit percentage is calculated by dividing the operating profit $ by the revenue from sales $. In the example above the operating profit percentage is 31%.

Now you understand the definitions of gross and operating profit you are ready to analyse these important performance indicators.

If this article interested you then you may also like:

Part I: Improving Gross Profit

Part II: Improving Gross Profit

Workbook: Gross Profit

Improving Gross Profit Part II

November 11th, 2013

Once you have improved your business gross profit at a macro level, it is time to look at the mix of products you offer and the gross profit of each. Bettering your gross profit at the product level requires you to look not only at the GP of each product, but also the volume of sales per product.

Consider the following business scenario:

The WGP% is the weighted GP percentage. A weighted value is one that has been normalised or adjusted proportionally to allow an apples-to-apples comparison.

In this table, the GP% has been multiplied by the sales volume % to calculate the WGP%.

The sum of the WGP% is the total business GP%.

  Product GP % Sales % WGP%
Widget A 35.0 20.0 7.0
Widget B 65.0 8.0 5.2
Widget C 25.0 50.0 12.5
Widget D 40.0 22.0 8.8
Total business gross profit % 33.5

If you looked only at the column listing the GP% per product you might conclude that Widget B is the highest contributor to gross profit, followed by widgets D, A and C. However, when you take into consideration the volume of sales and how that impacts on the WGP% we learn that:

  • Widget B contributes the least to the business gross profit; although it has the highest percentage GP, it is the least sold product
  • Widget C contributes the most to the business gross profit despite having the smallest GP% because it has the highest sales volume

So, how do you use this information to better your gross profit?

To have the greatest impact on GP through an increase in prices, increase the price of Widget C by only a small percentage to return a large GP increase. For example, if you increase the individual GP of Widget C by 3% to 28% the overall business GP% increases to 35%. However, if you increase the individual GP of Widget B by 3% to 68% the overall business GP% increases to only 33.7%.

The WGP% data can also provide guidance over where to assign your resources. If looking at product GP% only you might consider it more important to have team members assigned to manufacture Widget B, at the expense of resources for the other products. However, given that the business earns more GP from Widget C, ensuring the resources are assigned to meet the demand on the product creating the most GP would be a better management decision.

If a decision must be taken to drop a product from the product line i.e. because of a lack of resources, production lines or similar, ensure the WGP% is used to identify the lowest performing product, rather than relying of GP% in isolation of sales volume.

Want more?
Download the Systems Mentors Gross Profit Analysis workbook (Microsoft Excel 2007) and work through the GP exercises with your business data. Good luck!

If this article interested you then you may also like:

Basics: Profit Terminology

Part I: Improving Gross Profit

Workbook: Gross Profit

Improving Gross Profit Part I

November 11th, 2013

The real income of a business is the Gross Profit. Gross profit is the balance remaining from revenue when all variable costs have been paid. Variable costs are those specific to the product or service sold - the cost of goods or materials, production costs and the cost of labour to produce or deliver the product or service.

How does gross profit affect my business? Let us look to the following table (figures are ,000s):

P&L Statement Balance Sheet   The table represents a poorly performing business with respect to profitability. Although the business turns over $1.7M in sales each year, the high cost of labour erodes the revenue, producing only 35% gross profit.

Many business owners may try to increase turn over to improve the business bottom line. However, assuming gross profit persists at 35%, the turn over required to simply meet the business expenses and liabilities is $3,057,143 - that is 180% of the current income!

Income   1,700    
Materials 150      
Labour 950      
Direct Costs   1,100    
Gross Profit   600    
Indirect Costs   450    
Operating Profit   150     Profits Banked   150
    Liabilities   620
    Cash at Bank   -470

There are several ways to increase gross profit as a percentage of income:

  • Decrease the cost of goods sold; i.e. use alternate suppliers, or purchase in bulk
  • Decrease the cost of production e.g. lower labour rates, improved efficiency in manufacturing
  • Increase the sell price of goods or services
  • Minimise discounting practices
To examine the effect of these methods to improve the business profitablity let us re-examine the financial data after:

  • 1. Increasing the selling price of goods by 10%
  • 2. Decreasing the cost of labour by 10%

Without any increase in the volume of sales, these changes have resulted in a gross profit percentage of 46% and vastly improved the overall profitability of the enterprise.

  P&L Statement Balance Sheet
Income   1,870    
Materials 150      
Labour 855      
Direct Costs   1,005    
Gross Profit   865    
Indirect Costs   450    
Operating Profit   415     Profits Banked   415
    Liabilities   608
    Cash at Bank   -193

A combination of changes to the business model are recommended when seeking improved financial performance by increasing gross profit. Analysis should take into consideration not only the direct costs, but also the different products within the product range and the proportion of total sales comprised from each product and the varying gross profit percentages of each product. This next step in analysis of gross profit is covered in another article.

Want more?
Download the Systems Mentors Gross Profit Analysis workbook (Microsoft Excel 2007) and work through the GP exercises with your business data. Good luck!

If this article interested you then you may also like:

Basics: Profit Terminology

Part II: Improving Gross Profit

Workbook: Gross Profit

Conducting Effective Meetings

August 3rd, 2010

How well do you communicate with your team? Do you update your team on your business performance, issues you need their support to resolve and feedback on a job well done?

When the size of your team is small communicating one-to-one seems easier than calling a meeting. The logistics of getting everyone into one room and at a time when no one is busy on other tasks can seem more trouble than its worth.

However, calling your team to a meeting ensures that:

  • Everyone feels like part of the team
  • Your message is delivered as you’d like the team to hear it, and everyone receives the same messsage
  • Questions are asked and answered openly, allowing all team members to participate
  • You only have to say it once!

Effective meeting etiquette is important, however, to ensure the meeting is purposeful, achieves the outcome and does not have a negative impact. The following suggestions will help you conduct successful meetings:

  • Is the meeting necessary? Generally meetings are not 100% productive time for all attendees. If the objective is not to participate in two-way discussions but rather to present, and it is not of sufficient importance it needs to be delivered in person, consider an alternate method of communication, e.g. email bulletin.
  • Check the attendee list - If the meeting is to resolve a specific issue, invite only those directly affected. If a whole team is affected by an issue or decision, the team leader should attend only and take responsibility for relaying the information back to the team.
  • Be punctual - everyone should be ready to commence at the agreed time; do not recap for late comers
  • Take notes, distribute them and follow up - meeting notes provide a checklist for follow up and a means of making people accountable to their decisions and deadlines
  • Start with the most serious issues, and work down to the minor matters
  • No war stories - avoid distractions and veering off topic; important side issues should be scheduled for their own meeting
  • One meeting at a time - if team members start talking amongst themselves, bring their attention back to the meeting
  • Stay on time - plan before the meeting an estimated duration for each topic, and stick to it. If a topic is taking longer than planned consider having a separate meeting on just that one issue.

For small organisations a monthly meeting of a fixed duration - perhaps an hour - provides you with an opportunity to communicate important messages to your team, demonstrates that you are open and sharing with your staff and enables you to hear from the team the issues that are important to them.

Manage the meeting effectively and it will be an asset to your leadership.

If this article interested you then you may also like:

Manage: Alternate Meeting Strategies

Alternative Meeting Strategies

August 3rd, 2010

The traditional meeting format may be appropriate most of the time. But what if its not working for you?
There are many times when a round table, conference styled meeting is not appropriate - too formal, not focussed on one specific problem, too many people present, not enough time. Using an alternate format for the meeting may provide a solution to specific problems. Here are some examples:

Mary is responsible for overseeing the new inventory management software system. She needs everyone to attend an information session but the warehouse is flat out with customer orders and there is no time to bring everyone together. What is a good option for her to get these sessions done?
Lunch and learn has become a common phrase to describe an informative or training session conducted during a personnel lunch break. Mary could separate the team members into groups of 5 to 8 and invite them to a meeting room to have their lunch while she runs through the information session. With a team size of 40, that would allow her to complete the sessions in a week without impacting on the warehouse.

There is one sticky issue with lunch and learn - who pays for lunch? A good way to handle it is this:

  • If the team are "giving up" their lunch hour to attend a mandatory session, then for management to pay for lunch (typically $8-10 per person), the total cost would be less than one hour of overtime for each team member...so providing lunch is a good idea.
  • Lunch and learn sessions are often used for informal team training and are attended optionally. For these sessions team members should bring their own lunch.

John’s team are behind schedule on delivering a kitchen refit to a customer. They have a list of outstanding actions, but keeping everyone focussed on the list is proving hard. How can John communicate more effectively with the team without a meeting cutting into their time?
In this situation John should implement a "no chair" or "scrum" meeting. This type of meeting is typically used in two situations:

  • Team deadlines - the short, regular meeting style keeps the team focussed on the day’s events; if you get today’s tasks done, then you are not behind when you come in tomorrow!
  • Daily executive review - many larger corporations use this meeting each morning to recap any issues from the previous day, new actions for the current day and for the attendees to raise any issues proactively

The meeting is run in the following way:

  • The same person leads discussion at each meeting; typically this would be the leading tradesman, a project engineer or the coordinator who manages the list of tasks
  • All attendees stand; the meeting should take no longer than 15 minutes. If people sit they become comfortable and slow down the meeting. However, 15 minutes is not too long to stand and everyone stays more focussed.
  • Each person presents to the meeting; generally three items are raised in short form - think verbal bullet points! For example:
    • An item of concern not completed or that occurred yesterday
    • The main activity for today
    • Identifying a person shorthanded who needs help or a critical activity that remains unassigned

At the end of the meeting every person should know what they are tasked with doing and achieving for that day.

Pat’s plumbing business has a team of 20 who are on the road most of the day. The monthly team meeting has not been scheduled for two months because there has not been a time during the day when everyone is in the workshop. What can Pat do?
Pat’s best option is to schedule a meeting for first thing in the morning and ask the team to come in one hour early for the meeting. A morning meeting is good because everyone is fresh and the team probably comes in at least once a week to submit timesheets and other paperwork.
Some of the team may grumble about the extra hour. One option for managing that is to allow each team member to finish one hour early on one day during the subsequent month, in lieu of the meeting time. If a different team member finishes early each day, the impact on the business is minimal, and no one has been disadvantaged.

If this article interested you then you may also like:

Manage: Effective Meetings