Gross Profit and Net Proifits
Welcome to the Business Made Easy podcast, brought to you by convexaccounting.co.nz.
Riann Umaga-Marshall: Hi, I'm Riann Umaga-Marshall.
Hamish Mexted: And I'm Hamish Mexted.
Riann Umaga-Marshall: And welcome to Business Made Easy.
Hamish Mexted: In today's podcast we're covering the concept of margin. And this is something that business owner's ask us about all the time, but are never quite sure what it really means, and what numbers they need to be looking at in their Xero account. So, they log into their Xero account, and they go, I want to find out some ratios about my business, but don't have any idea where to begin.
So, one ratio that is more important than any other is your margin. Which comes in two real forms. So, the first form is the net profit margin, and here we're looking at, in percentage terms, how much of every dollar you end up keeping and final net profit. So, how much of every dollar of sales turns into a dollar of profit at the end of the day.
So, for example, if you have $100.00 of sales, and you have $20.00 of net profit at the end, your gross of your net profit margin is 20%. The other concept is your gross profit margin, and here we're comparing your total sales against your gross profit instead of against your net profit. And I guess the key in understanding these two concepts is exactly that, it's understanding what forms your gross profit and what forms your net profit.
And fundamentally it comes down to the different types of expenses within your business. Primarily what we're talking is the difference between your operating expenses, so these are things like rent, stationary, motor vehicle expenses, the stuff that you're going to pay for in your business whether you have a dollar of sales or a thousand dollars of sales. It's the business as usual things that take over, no matter what.
So, they're your operating expenses. And then on the other hand we've got your direct costs, or your costs of sales. So, these are things which fluctuate depending on how much you sell. So, if you're a retailer your direct costs are going to be obviously the things that you sell in your shop. So, if you sell clothes, it's going to be the clothes that you have to buy from your suppliers to sell to your customers. At a level that's also going to be your wages, because if you extend your shops opening hours, you're obviously going to sell more because you're open for longer. But at the same time, you're going to have to pay your staff more because they're at work more.
So, your costs of sales or your direct costs will be your wages plus the things you're selling. If you're a manufacturer on the hand, your cost of sales are going to be a lot broader because you're going to have the staff wages for manning your equipment and for turning the machines on and off, and keeping everything going. You're going to have the raw materials that you sell, which will be the inputs that you buy from your suppliers to turn into whatever it is you're making. But you’re also going to have things like power. So, the more you run your equipment, the more you're going to sell, but the more you run your equipment, the higher your power bill's going to be.
So, for those sorts of industries, the direct costs can be much more variable. And for us as an accounting business for example, our power bill is relatively fixed no matter how much work we do. So, we're going to treat that power bill as an operating cost. Whereas for a manufacturer they're going to look at it more as direct cost which correlates very tightly with their cost of sales.
The starting point for any business is to start to work out where they spend their money, what gets classified as an operating cost, or an overhead, and what gets classed as a direct cost or a cost of sales. And once you've got that sorted out, you can then start to pull your net profit ratio and your gross profit ratio in a way that's really applicable for you and your business.
Riann Umaga-Marshall: The main thing is here getting your Xero chart of accounts set up right. If the information you're feeding in isn't able to be reported out to you accurately, you're not going to be able to use the information to make these important decisions within your business. So, if you need help getting that sorted out, click us a message and we can sort that out for you.
Hamish Mexted: Well, that's all we've got time for today, but for more information on what we've covered check out our website, convexaccounting.co.nz/podcasts and then select episode eight. There you're going to find a whole bunch of resources around how you should manage your operating costs versus your direct costs.
And a little bit of a teaser on what we're going to cover in our next episode, episode nine, we're going to look at what you can do to increase your margin. Quickly though, there's three options, right. You either sell more, you drop your costs, or you increase your prices. But look, we'll have more on that next week, so make sure you tune in and find out more.
If your listening to this podcast close to when it was first published, you might also be able to join our community call. In our community call, we've got a group of real world businesses coming together to share what they've done in practice, the wins, the losses, the successes, and failures, what they've done in practice to improve their margin. So, if you'd like to find out more on our community call or get involved, reach out to us through out website, and for more information.
So, yeah, as I said, in the meantime, jump on the website, convexaccounting.co.nz/podcasts and select episode eight and there's a heap more of information there for you. Thanks for tuning in.
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