Gross vs Net Profit
While most companies review their budgets on a regular basis, many of them underestimate the strategic value these meetings can contribute to their company. Instead, they simply view these reports as static updates with little value to add.
Today, we’re offering two ways to use these meetings more strategically. When you analyze your company’s gross and net profit, and compare the two, you will be surprised at how much information you will have access to, and how much this will set you up for success.
On today’s episode you’ll hear:
- An in-depth explanation of gross profit
- How gross profit compares to net profit
- How you can use both gross and net profit to strategically evaluate your business and, if you’re interested, other businesses as well
If you’re looking to get even more value out of your regular budget meetings, then this is one episode you won’t want to miss.
Transcription of This Episode
The Gross Profit Podcast is your one-stop shop on the path to profitability. Each week we share authentic advice on the positive, practical steps you can take to make the company you love more profitable. If you’re looking for a positive plan to help you avoid common spending mistakes, control costs, and increase your profits, then this is the place for you.
I’m Ryan Cowden and this week we’re joined by James Kennedy and Garret Carragher. In this episode of the Gross Profit Podcast, James and Garret discuss the important distinctions between gross profit and net profit. While most companies review their budgets on a regular basis, many of them underestimate the strategic value these meetings can add to their company. Instead, they simply view these reports as static updates with little value to add. Today we’re offering two ways to use these meetings more strategically. When you analyze your company’s gross profit and net profit and compare the two, you will be surprised at how much information you will have access to and how much this will set you up for success.
On today’s episode you’ll hear an in-depth explanation of gross profit. Your gross profit refers to how much your company has made after you subtract the costs directly related to delivering goods and services. Tracking your gross profit is a great way to determine how efficient your company is, and to compare your company with the other competitors in your industry.
Next, we’ll discuss how gross profit compares with net profit. Net profit factors in all the other costs of your company not directly related to delivering goods and services. When you compare these numbers, you may be surprised at what you find.
We’ll also discuss how you can use both net profit and gross profit to strategically evaluate your business, and if you’re interested, other businesses as well. Monthly budgetary meetings where you analyze your gross profit are the best ways to catch fluctuations in your business. And comparing your gross profit to your net profit allows you to identify potential areas of waste or inefficiency in your company, and in other companies you may be curious about.
If you’re looking to get even more value out of your regular budget meetings, then this is one episode you won’t want to miss. There’s a lot of actionable advice in this episode so grab something to write with because you’re going to want to take notes. As always, I’ll be back on the other side to wrap up any loose ends. So, without any further ado, here’s our conversation with James and Garret.
Hello, it’s James Kennedy here, CEO of procurementexpress.com, where we help hundreds of companies safely spend billions of dollars each year. I return guest here with the secret CFO, Garret Carragher. Garret Carragher, how are you?
[inaudible 00:02:59] posing after an exciting trip to MicroComp. Really it was a great trip. Great stuff learned there, great tips picked up, I recommend anyone to head over some time is to get the chance, you know,
Beautiful Dubrovnik by the azul blue Mediterranean or Adriatic, was it? Just me, you and the sunset, it was gorgeous Garret. I’m so glad I got to share that knowledge with him.
That’s so romantic. If only we had an Instagram account for our podcast here. We could set up some lovey pictures of us walking hand in hand around Dubrovnik, you know, it’d just be absolutely beautiful. But anyway, it was great. It was a great conference, some great speakers at it, and I really learned a lot from it, you know?
Yeah, it was fascinating. Those guys always have interesting stuff and it was brilliant location. So tarry-o, that’s it till next year, back to rainy Dublin for me, but that’s okay. I can take it.
So okay, today we’re going to get into table stakes, which is net and gross profit. And we’re going to get into what it is, why you might want to consider the two. I have a couple of issues to ask Garret here about it, but maybe Garret, you can kick us off. Let’s cover the basics. So what’s gross and net profit?
Yes. So these are very important parts of anyone’s accounts and a lot of people might look at them and not really understand the difference between the gross profit and their net profit. So it’s really important to have, just somebody sit down with our accountant and kind of run through it and say, okay, you’ve made this much in the month. And although that’s important to know, it’s also important to know why, why the two of them are split and what does she mean? And then how you can use them to gain valuable insights into your business to create actions then to drive your business forward.
So if we think about, gross profit, first of all, so gross profit really is all the costs that are in the business that are required to deliver a service or your product. So if we think about it, so you start off with your revenue, you take off all the costs that are related to delivering your service or your product and that will give you your gross profit after that. So it’s a very strong and exacting definition. You know, you really have to understand your numbers and make sure you take off the correct items that directly affect or directly relate to you delivering your service or your product to get down to your gross profit.
So is it, I mean is it as simple as net profit takes into account your overheads, your efficiency and everything caught in your gross profit just relates to cost of goods sold or what else do you have to consider in your gross profit versus net profit?
Yeah, so thinking about gross profit, what’s the importance of the gross profit or why do people do that? The gross profit is super important function. And what it will tell you is how efficient you are at delivering your product or service, and that’s the key point to take away from your gross profit. So whenever you look at that number that is really telling you how efficient you can do your job or how efficient your businesses are doing its key activities or its core competencies. And what you can do with that then is you can immediately start looking in your industry. They’re available online.
You can find out what your industry average is. What’s the best in industry, worst in industry. You can even go to the company’s house in UK or the CRO in Ireland and pull down accounts from other companies, even close competitors, and have a look at their accounts and see what gross profit they’re making. And that really gives you an insight then into how you, how efficient you are in your business. So you know, how much costs are you spending on direct labor, how much costs you spending on direct materials. Any other costs that are directly related to delivering, so that might be, a CFD person in there. You might have warehouse and a warehouse staff. And then obviously carriage and shipping to get the goods out then to your stores or to your customers.
So benchmarking then is, that’s the thing is when it comes down to, I guess we’re talking, this is classic financial accounts we’re talking about here, and it’s really when it comes to buying or selling a company, is that when these different figures become really important or is there a day to day sort of management accountant reason to do it as well?
Yes, it was super important to look at it on a monthly basis because it will tell you how your team have performed in the month on doing the work in the business, on actually providing a good and services in the business in the month and it really gives you amazing insights into what’s going on at your business and you can quickly see, okay, our gross profit percentage was you said 40% in June and that dropped down to 35% in July under the reason there’s a reason for that. There’s a reason for that 5% drop and you need to find it.
So has someone been discounting your goods, have you been selling products at a lower margin than you had in June? Has there been more overtime, more direct labor costs? Was there something wrong with materials? Did you get a shipment of goods in and half of them was dumped because it was obsolete or damaged and you couldn’t bill it back to the supplier? Have you taken on more staff? Why have you taken on more staff? Have you been using contracting staff instead of your own staff? Has someone been out sick and not pulling their weight? No, maybe they’re sick. I’m not saying he can’t get sick. But you know all these things feed into your gross profit number.
Oh I noticed Garret that you left out the accounts team screwing up the accruals. That’s why it dropped off. It disappeared. It’s not normally reason.
Of course, and that’s, that’s the key thing where you know we probably haven’t done a podcast on accrual accounts, but it’s super important that your team are using the latest software and are making the correct accruals into the accounts each month for like materials, labor that kind of stuff and you have the correct numbers in there. Otherwise, it’s telling you nothing, it’s telling you a load of rubbish and you might make a big decision based on misinformation, which is not good for anyone. So that’s the gross profit percentage and that’s why it’s so important to look at it on a monthly basis. You can also look at it then across different companies and rank yourself within your industry.
So allow me, what do you do, let’s say in your example there, you take in materials, let’s say a pallet of widgets you use to make your product. You buy it for the year in January, create a big loss, let’s say. Or you know you pay for that but you want to– that pallet of widgets is actually part of your cost of good sale. But how do you account for that? How do you, where do you keep it when you pay it out at first and how do you spread that across as a cost to put sale? Cause it’s kind of in between the two essentially. I mean it’s an overhead cost in that you bought the widgets and it’s not until you sell the thing you realize the profit on it.
Yes. So you buy the widgets and it goes into stock. So the widgets go into stock and it sits in stock den. And as you draw them out and use them over the year, it’ll hit into your cost of goods sold. So go straight into direct materials and that’s where you can see what’s going on. So if you’ve bought your widgets at the start of the year and you said, I’m going to be able to sell these widgets at one Euro and it costs me 40 cent or cost me say 60 cent, that means you’re making a 40 and that’s your only cost in that means to make a 40% gross profit on each of those widgets, you see? You’re saying I’m selling them for one Euro, it costs me 60 cent, that’s 40 cents I’m making in profit. So if you go to year, you get to middle of the year, suddenly there’s an oversupply of widgets.
Everyone has widgets, there’s widgets coming out of people’s ears, we’re sick of widgets. You know, and you go to sell your widgets now and you can only sell them for 90 cent or you only sell them for 80 cent. So you can see straight away your GP is going to drop 10 or 20% based on that immediately, and that’s going to hit you in the account. So you’re looking at your accounts, you’re going, “Hold on now, something’s gone wrong here. What’s happened?” Now you say, “Oh yeah, you bought too many of these widgets back in January. We shouldn’t have bought a full pallet. We only needed to buy three or found hundred of them instead of buying 5,000 and now we’re selling them on a loss. Or we’re not selling them at a loss, but we’ve reduced our gross profit across the year.” And that’s one example. And that’s why when you also do this, when you look at your gross profit, you look at it not only by the overall, but it’s important to break it down by products or services.
So if you’re selling different products, you can break it down quite easily there. And most accounting systems will do that for you quite easily. Or if you’re looking at if you’re selling a service, what you need to do is, it’s a bit more difficult to be honest. But you need to get in your cost there using maybe time sheets to core people’s labor, get it allocated into the right job, and then see what you sold the job for an allocating the right costs, you know, based on the people’s time from the time sheets. And that would give you a gross profit on each of those jobs, which will add up to your total gross profit in the month.
What you’d be able to look at each of the jobs and suddenly you might get a great insight, which is that jobs that we’re doing for an a company in Cary, which is a long way from where our head office is, is not profitable because it’s taking five hours to drive up and down and you might suddenly realize we shouldn’t be doing any jobs in Cary because we can actually get more jobs in Dublin or around Lannister or whatever and that’s going to save us a lot of money and going to make us more money in the gross profits.
So does that mean that if, when you buy in those widgets, it doesn’t affect your amount, your net profit for that month, you just wait until you sell it on again as a cost of goods sold and that’s where you see it. That’s where you take that cost.
Yeah, exactly. Yes. So when you’re buying items, you’ve actually, in that case, you have actually bought an asset, so it goes into your stock as an asset. So it sits on your balance sheet as an asset. So it sits there and as you use the asset, as you expend the asset, as it moves along and you sell it, you know, or maybe use it in a manufacturing or whatever, you use it for, the asset to value of asset, will go down. So when you think about it, if I have something, it’s an asset and it’s worth a hundred on it cause I use 10 of them under each one Euro each time means I’ve lost ten Euro. So really the 10 Euro was a cost, and the cost goes into your accounts as a cost and hopefully then you’ve got revenue to offset that.
Very good. So if I am, let’s go a quick hypothetical here. So let’s say I’ve got oh, big gross profit, everything looks great, but the net profit is, is negligible. Does that just mean… what does that tell me about the company?
Yeah so, if we get into what’s in the net profits, we need to understand what’s in that. So net profit is like to get to your net profit from your gross, you really need to take away all your other expenses involved in your company. So they’re, they’re kind of known as overheads, you know, so they’re not really directly attributable to delivery of your products or services, but they’re still a cost. So that might be, what are they? Well it’ll be sales and marketing. It would be like financial people or financial department. Your management would also go in there, your CEO, MD, anything like operations managers, anything like that. You’d also take off stuff like depreciation. So if you’ve bought cars or equipment, office, equipment, laptops, all that stuff, that would all be depreciated, that’ll all go in there as a cost.
And then you have a bit of tax as well. If you do pay tax, I know you never pay a tax Jim, so that’s probably not a concern for you. But anyone else who pays tax would have to go in there. So when you think about it then if you’re looking at a good gross profit on a low net profits, that means there are a lot of expenses in there that aren’t actually, you know, involved in the delivery of the products and the services to the customer. And that’s quite interesting isn’t it? Because, if I was sitting there and I was in the same industry and I was looking at this company and I started seeing that this company is making a big gross profit because it’s delivering things efficiently, it’s charging a nice price and it doesn’t have much costs in there.
It’s actually making higher than the industry average, but its overheads are massive. And I’d be looking now to the overheads and I’d say, “Hold on. The managing director’s taken a massive salary. All the management are getting huge salaries. They have a massive finance team, which I don’t think the need and they have a big IT support, I mean do they really need that? I don’t know, maybe we don’t need that.” And I’d be thinking, “I could actually buy this company over, consolidated into my company, and use my management team, my finance team and my support team to run that company and I could just take all that gross profit for myself and really have very little overheads left.” So that is a key insight there. If anyone out there is ever thinking of buying a business is to actually look at the gross profit, see does it look good, and then move down through the overhead expenses and see what ones you can knock out because anyone you can knock out is going to increase the profit for you.
That’s pretty interesting actually. I, as a software company, I hadn’t really caught my head around why net versus gross, what we would do in our gross profits are above the line. We would have, is that the right expression? Above the line no? Where you put your cost to good sale router, we put in our advertising costs, sales commission, things like that, and all of the other stuff will be, you know, come out of our net profit. So all your running expenses. Obviously with a software company that’s a lot of, you know there’s a lot of overhead if you like in terms of software engineers that are hard to directly attribute to the product itself as a cost of good sale.
But I can see how okay someone else wants to come along and buy us, they can have a look at our gross profit router and then say, okay, all these other things actually might be something that they might already have. Or conversely, if we’re looking at a company to buy, I guess we could say I’m going to buy another software company. We could look at maybe we don’t need their engineers, or maybe we don’t need as much marketing or whatever. Does that make sense?
Yeah, that’s, that’s the way it works. You know? That’s why it’s very interesting. If you watch big takeovers of companies on a stock exchange, you see the share price either going up or down on. Really what has happened is the analysts are looking at the companies and seeing where the synergies are and where the cost is going to disappear. I hope that makes sense. So they’re looking in there. So a big one might’ve been a famous one. There was HP and Compaq, so a HP boss, Compaq computers. And at the time the share price went down in HP and then went… the analyst did not think this was a good purchase, and it turned out to be true because when they had bought the Compaq, they weren’t able to deliver the cost savings, so they weren’t able to cut out support teams or finance or whatever, I don’t know what the big cost was there in their overheads.
Thought they were going to dump, but they weren’t able to dump it, and that meant they weren’t able to make massive savings and they weren’t able to create great synergies and increased a profit of the two of them substantially. You know? So it’s always quite interesting to watch the bigger companies in the case of smaller companies like yourself or other companies at that, you know, they are not as big as HP, which a lot of companies aren’t the biggest HP, let’s be honest. It’s all about yourself looking at the other company and just understanding, you know, what’s in these overhead costs, you know, that I can get rid of. You know, and mostly it’s like managing, if the founders in there, they’re taking a big whack of money and it means that you can see that that’s going to go, that’s going to be gone.
So it’s not the net profits you’re going to get if you buy the company, it’s the net profit plus all those other costs you can dump, which you include like the big ones which is the founder’s salaries or other stuff that you don’t need. Maybe they have an expensive building or you know, expensive equipment that are depreciating or whatever. And you might say, you know, we don’t need that stuff anymore. We just sell that off and take all that out of the accounts, you know.
That sounds like a great idea. I guess paying the founders all the money. I love that. I’ll bring that up at the board meeting next time. Oh, I’ll have you know that we, for the size of us, we pay more tax in more countries than we basically have people almost much to my chagrin, but there you go. That’s the international nature of business these days. Pak Karachi, South Africa, Ireland? Probably a couple of other governments in there every time I look at it.
Well here you go. That’s the nature of international business. You just have to pay it when you have to pay it, you know?
So that’s very good. That’s, what else should we consider when it comes to gross and net profit or have we covered everything?
Well, I think we’ve covered the main things there as, as we said, it’s the most important thing I think with gross profit is to analyze it monthly. I mean analyze it monthly, compare it back to your own gross profit for prior months. And, if you don’t understand why it’s moved, you need to understand or you need to change your accountant, because you should understand why it’s moving up and down each month. And that might be, someone’s offered a discount. All of the things we’ve listed, there are so many things that can affect it, but it’s really getting an insight in there and really understanding the gross profit and you know, drilling down by job or by product or whatever because really most of the time your overheads are probably going to stay more or less the same, aren’t they? So the gross profit can go up or down, you know, are you going to need more people to finance?
Probably not. Are you going to need more people in MD or MD or more management? Usually not unless it increases substantially. So most of the time your overheads are kind of sitting at the same number each month, month on month. But it’s your gross profit that really delivers to you, and you need to understand what’s making that going up and down. So everyone out there go and get your accounts out. Get your accountant there and start going through the detail and get them to explain to you why the numbers are moving up and down. So you understand that in detail.
Great stuff, Garret. Well thanks very much for explaining that to us. And until next time, we’ll see you again.
All right, folks, there you have it. That wraps up our conversation with James and Garret. They shared a ton of valuable insights and advice today on how to strategically understand your company’s gross and net profits. We also shared some tools and resources, which will all be linked up in the show notes. Don’t forget to click on one of those links to get a free chapter from the book profit leaks by James Kennedy and Garret Carragher I hope you enjoyed our conversation. Please consider subscribing, sharing with a friend or leaving us a review in your favorite podcast directory. Until next time, best of luck in all that you do and we’ll look forward to seeing you on the next episode of the gross profit podcast.