Knowing the Difference Between Earnings and Profit

One of the oldest business axioms is also one of the truest: It’s not what you earn, it’s what you keep. Not understanding the difference between earnings and profit is one of the biggest mistakes many new business owners make.

This problem is especially common among businesses that are paid at the point of sale, but don’t have to pay vendors and suppliers until later. Consider a typical restaurant. At the end of the week, it could be swimming in cash from sales. But once rent, utilities, payroll, food supplies, insurance, and other expenses come due at the end of the month, all that cash can vanish. In fact, more restaurants close due to a lack of understanding the difference between profit and cash than for any other reason.

What Is Profit?

There’s a big difference between the money a business collects, or its revenue, and the money left after all expenses are paid, its profit. For most businesses, expenses must be paid out of revenue. Whatever money is left after it’s paid all of the expenses incurred to manufacture and deliver a product or service is its profit.

Growing your profit starts with understanding the concept of profit margin, or the difference between profit and sales. For example, if your business collects $2,000 for the delivery of a finished product, but it cost you $1,000 in materials, labor, and overhead to manufacture that product, your profit margin would be 50 percent (1,000 divided by 2,000 equals 0.5, or 50 percent). If you reduce your material, labor, and overhead expenses to $800, your profit margin would grow to 60 percent and your profit to $1,200.

The profit margin calculation can be taken a step further by distinguishing between gross profit and net profit. Gross profit is what’s left after you subtract the direct costs of manufacturing a product or providing a service, like materials and direct labor costs. (This is also known as cost of goods sold, or CGS.) Net profit subtracts overhead, payroll, taxes, and all other business expenses to arrive at what’s often called the bottom line.

Growing Your Profit and Margins

Growing your profit margin isn’t rocket science. It requires either reducing your costs, increasing your revenue, or both. You can cut costs in many ways, such as:

• Curb miscellaneous expenses. Be careful not to overspend on “little” things like office supplies, overnight shipping, and meals and entertainment. They can add up fast.
• Watch raw material costs. Ask your suppliers if there are ways you can save on raw material costs, such as by purchasing in bulk or paying invoices early and receiving a discount.
• Barter. Try trading with other businesses for things they need. For example, you could barter your product or service with a magazine or newspaper in exchange for a display ad.

Here are a few ways to increase your revenue:

• Segment customers and products. By determining in what key ways your customers and products are different, you can target your product offerings and marketing efforts more tightly. This can also help you identify which of your products are stars, cash cows, question marks, and dogs so you can invest your sales and marketing resources more effectively.
• Create ancillary products and services. You can add these bells and whistles to existing products or services and charge extra. They should cost you little or nothing, thus adding directly to your bottom line.
• Raise prices. This seems obvious, but it must be done carefully, especially during tight economic times. Ideally you should offer additional value along with the higher price so customers don’t perceive it as a price increase but rather as a value add.

Don Sadler is a freelance writer specializing in business and finance. Reach him at don@donsadlerwriter.com.