Gross vs net profit: Why numbers are deceiving
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August 27, 2021#6 What the hell is that?
September 21, 2021In the world of business, your earnings can make a large difference between getting investors to invest in your business and being completely overlooked. Many business owners think that the more money they bring in, the more likely it is that investors will show interest. This is true to some extent, but in actuality, thinking only about how much money you can make is a sign of short-sightedness.
Why is looking to make as much as possible a bad goal?
Everybody who has spent even a single class in a business/economics course should have some understanding of the difference between gross and net profit. But for clarity’s sake, let’s look at it in closer detail.
Fact number 1: Greater gross profit does not mean a greater profit margin
Gross profit is all the revenue made by the business minus the cost of the goods they sell. A shoemaker that sells 100 pairs of shoes at R300 a pair, and who makes each pair at a cost of R100, will have a gross profit of R200 per pair and make a gross profit of R20 000.
This number, however, is misleading because it does not include any operational expenses, taxes or other relevant expenses. It also does not consider gross profit margins which, in the above scenario, would be around 66.7%.
To illustrate this, let’s say the same shoemaker were to improve the quality of their shoes, but it would increase the manufacturing cost to R 200 per pair. Naturally, they would want to up their sale price. The shoemaker discovers that for the new shoe, consumers would be willing to pay R 450. So, if they were to sell 100 of these shoes at R 450 a pair, they would make R 250 gross profit on each pair of shoes and R 25 000 gross profit. However, in this scenario, the gross profit margin would have gone down to 55.6%, essentially meaning that less profit is derived per Rand spent.
While the total gross profit increases, the strategy implemented by the shoemaker might actually cost them in the long run.
Fact number 2: Larger gross profit does not mean more net profit
Let us take it one step further and consider operational expenses. Say, in the first scenario, that the shoemaker’s operational expenses relative to each pair of shoes is R50. This would mean that (tax and other possible expenses not considered) the profit on each pair sold at R300, made at R100, with R50 operational expense per pair, equals to R150, and the profit margin is exactly 50%.
In the second scenario, where the higher quality shoe is sold at R450 but produced at R200, let us imagine that the production cost and operational expenses per pair are directly proportional and that the operating expense per pair amounts to R100. In this scenario the net profit per pair (R450 – R200 – R100) remains R150, but the profit margin drastically drops to 33.3%. While Gross profit from the first to second scenario increases, net profit remains the same.
Fact number 3: Net profit should be the focus
Society has almost been conditioned to believe that more is, well, more. Yet, what the hypothetical scenario shows is that everything in one’s business should be well-planned and structured with a clear strategy and not just “how can we get more revenue”. In some cases, an increase in gross profit could even lead to decreases in net profit and even greater decreases in profit margins – especially when taxes, interest on debt, and other expenses are factored in.
This is why working with an accounting specialist is crucial in our modern business world. And when practical accounting excellence is married with good business financial advice, it can only lead to greater growth and better profit strategies that do not only rely on going bigger, gaining more revenue, and seeing large numbers, but that focuses on reaching the optimal net profit margin that can sustain long term success.
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This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)
