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ProfitWell MetricsLearn what the profit equation is, how to calculate different types of profit, and why it is important to keep track of company profitability.
As a profit-making organization, your key bottom line is generating profits for shareholders. While the term profit sounds fairly straightforward, there's a lot more to it you need to know. Such insight will help you determine ideal prices for goods and services and operate more efficiently. This is where a profit equation comes to into play.
In this article, you'll learn about the types of profit, the profit equation, and how to calculate them.
What is the profit equation?
Profit is the total amount by which your revenue exceeds costs over a given period of time. In its simplest form, the profit equation is:
Profit = Revenue - Cost
Revenue represents all positive cash flow earned by a business, while costs include both variable costs and fixed costs. Profit is the amount that remains after factoring cash flow in and out of the business. There are three types of profit equations commonly used by businesses: gross profit equation, operation profit equation, and net profit equation.
We will dive into the nuances of each in the next section.
What are different types of profit & how to calculate them?
While the concept of profit is simple, there's a lot more to it. First, there are different types of profit, each with a different formula. By calculating them, you'll gain a much clearer picture of the company's profitability and efficiency.
1. Gross profit equation
When it comes to profit calculation, gross profit is the most basic. Under this equation, any income that remains after deducting the cost of goods sold (COGS) qualifies as profit. COGS refers to the direct costs of production such as wages and raw materials.
In essence, gross profit gives you a reflection of the proportion of the dollar value the company retains after paying for the direct cost of production. As such, it does not account for overhead costs, taxes, debt payments, and one-time expenses such as equipment purchases.
The gross profit formula is as follows:
Gross profit margin = (Net sales – COGS) ÷ Net sales
2. Operating profit equation
For small business owners, going on gross profit margin may suffice. However, for a growing company you'll need to go a level further and calculate the operating profit. In doing so, you'll also account for all administrative, operating, overhead, and sales expenses you incur for day-to-day business operations.
However, there are some cost factors that operating profit does not account for. These include nonoperational expenses, taxes, and debts. Nonetheless, you'll need to include the depreciation of assets and amortization.
By calculating operating profit, you'll know the proportion of money in relation to revenues that your business retains after paying for all the operating expenses.
The operating profit equation is as follows:
Operating Profit Margin= (Operating Income ÷ Revenue) × 100
3. Net profit equation
The previous equations are ideal and provide key insights. However, you'll ultimately need to know how much is left after accounting for all expenses and revenue streams. This is known as the net profit, which reflects your company's ability to convert income into profit.
As such, while calculating net profit, you'll factor in operational expenses, COGS, one-time expenses, and debt repayments. Moreover, it will also include revenues from secondary operations and investments.
There are two formulas you can use to calculate net profit. They are:
Net profit margin= ({Revenue – COGS – operating expenses – other expenses – Taxes – Interest} ÷ revenue) × 100
Alternatively, you can use:
Net Profit Margin = (Net income ÷ Revenue) × 100
3 biggest limitations of profit equations
Undoubtedly, profit equations can help you learn more about your company. With this information, you can improve operational efficiency and improve your pricing strategy. However, they also have limitations.
1. Broad time period
Often, organizations calculate profits quarterly, bi-annually, or annually. While you have an accurate picture for that period's profits, you may miss some key insight.
Suppose you calculate profits annually. This means that you'll only identify the limiting factors at the end of the accounting period. However, if you calculate profit margin monthly, you'll identify limiting factors much sooner. As such, you can address them much earlier and increase profitability for the year.
2. Inclusion of one-time revenue/expenses
At times, unique opportunities may arise, allowing you to make additional revenue. However, while they may contribute significantly to your profits for that period, they may give a wrong impression of your overall profitability.
This is because that source of revenue is not one you can expect in subsequent accounting periods. As such, each time there are one-time revenues, you should avoid including them when making projections.
In the same vein, you may also have to spend money on something that's not part of recurring expenditure. This may be for infrastructure, equipment, etc. If so, your profits for that period will be lower, indicating that the business is worse off than it actually is.
3. Room for manipulation
The value of calculating profit margins is undeniable. However, reports may not always showcase the actual state of a company's financial health. This is because of financial statement manipulation, which happens to present an organization as being healthier than it is.
Executives may do so to attract investors or to secure performance-related benefits. Sadly, it's as easy as recording revenue prematurely and is often very hard to detect.
Why understanding company profit is so important
Beyond knowing how much is left after deducting expenses, calculating profits provides a lot of strategic insight. As a result, it enhances planning and decision-making.
1. Indication of a company's financial health
One of the biggest mistakes entrepreneurs make is assuming that lots of sales mean the business is doing well. As much as you may be making money, you may also be leaking it elsewhere.
For instance, your business may have a good gross profit margin. This may give you the impression that you're highly profitable. However, upon calculating operating profit, you may realize that the operating expenses are too high.
As such, calculating the different types of profit is essential. As a result, you will have an accurate picture of the company's health. Moreover, you can pinpoint avenues where you can improve to increase profitability.
2. Simplified and more accurate budgeting
For any given financial period, you will incur costs. To keep such expenses manageable, it's essential to create a budget for that period. In most cases, that budget will account for revenues you roll over from the previous period and projections for the coming one.
Should there be any errors in your profit projections, there's a high chance you'll have a budget deficit. With this, some of the company's projects may be derailed, leading to further revenue and profit reduction.
By having a clear picture of the revenues and profits to expect, it will be much easier to create budgets. With this, the risk of such budget deficits also goes down significantly.
3. Greater investment opportunities
A key part of scaling is increasing investments. For you to identify the best investment options and capitalize on them, you need to be strategic. One key element for this is knowing how much you can spare for such investments and at what point.
As you calculate profit using the various formulas, you'll have a clearer picture of how much you can allocate to investments. You'll then be able to focus on investments that fit your capacity, allowing you to assess them at a deeper level and choose the best one.
4. Maximized business growth
Calculating various profit margins has several benefits. Collectively, these benefits help you maximize business growth. By helping you to optimize business operations and enhance planning, you'll be able to make the most out of the resources you have.
These can then be channeled to strategic investment opportunities to stimulate further growth.
Tools to help grow your profit
Gain better insight into your business's financial health with ProfitWell Metrics
As you endeavor to gain a deeper and clearer understanding of your financial health, you'll need analytics software. And ProfitWell Metrics is the ideal solution. It helps you track key business metrics for accurate financial reporting. These include:
- Revenue
- Acquisition
- Retention
- Engagement
Beyond tracking metrics, it offers analytics from the same. As such, you'll have full visibility of your company's financial health.
Reduce churn with ProfitWell Retain to impact overall profitability
One of the most important metrics for a subscription-based business is retention. This is because profitability greatly relies on recurring revenue. As such, minimizing churn is integral to success. Some of the steps you can take to achieve this include:
- Have clearly defined churn goals
- Offer incentives such as free trial periods
- Enhance the quality of service
- Have a support strategy
- Build relationships with your users
ProfitWell Retain is a solution designed to help you improve customer retention. It will help you monitor churn and identify the primary contributors. As such, you'll be in a better position to develop and implement remedial measures to improve retention.
Take the headache out of growing your software business
We handle your payments, tax, subscription management and more, so you can focus on growing your software and subscription business.
Profit equation FAQs
The success of any management team and company boils down to profitability. As such, you must familiarize yourself with the key profit-related topics. In this regard, these are some of the key profit equation FAQs:
1. What is profit and what does it say about my business?
Profit refers to the excess amount that remains after you deduct expenses from revenues. It's a measure of how efficiently you use and convert resources into monetary value.
2. Which factors influence company profit?
There are many factors that influence a company's profit. These include the cost of labor, raw materials, debts, administrative costs, and nonoperational costs. Other than expenses, sales volumes and pricing are key.
3. What is the profit margin equation?
The profit margin equation refers to the formula you can use to calculate profit. However, since there are different types of profit, there are various equations you can use.
4. How do I calculate profit per unit?
A crucial part of understanding company profit is to know the profit per unit. For this, you'll need to calculate the production cost per unit and subtract it from the sale price.
5. How do I calculate profit per share?
A company's pursuit of profit is for the benefit of shareholders. As such, before issuing dividends, you'll need to calculate profit per share. For this, you'll need to calculate the net profit and divide it by the number of outstanding shares.
