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.
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