Tuesday, January 4, 2011

Types of Profit - Profit Ain't Just Profit

Remember the old Wendy's commercial in the 1980's when they were trying to make their chicken sandwiches seem better than their other fast food competitors...

When showing a picture of what seemed to be a nameless competitor, the person kept repeating..."Parts is Parts," referring to the so-called fact that all parts of the chicken are the same on a sandwich.

Wendy's; however, knew the difference (so they said). They knew that all parts of the chicken ain't the same.

People roll their eyes, but essentially many people do the same thing when it comes to profit. They'll simply ask, "What was their profit margin?"

Types of Profit

There are different types of profit that reflect different stages of the business:
  • Gross Profit
  • Operational Profit
  • Pre-Tax Profit
  • Net Profit
I will try to explain each using a child's lemonade stand as an example.

Gross Profit: Your total sales is your total revenue. However, it costs you money to purchase the products (goods) to make what you sold.

Gross Profit = Total Revenue - Cost of Goods Sold (COGS)

Example: You sold 50 cups of lemonade at $1.00/cup. So your total revenue was $50.00. However, you had to buy your materials, and they cost a total of $20.00.

So you're Gross Profit = $50.00 - $20.00 = $30.00 Gross Profit.

Quick Reference: Gross Profit = Money Collected - Cost of Stuff to Make What You Sold

Operational Profit: After you figure your Gross Profit, you still have everyday expenses to run the business. (You might only have to pay those expenses once a month or whatever, but...) These are the expenses that you need to continue operating your business.

Operational Profit = Gross Profit - Operational Expenses

Alternately...

Operational Profit = Total Revenue - COGS - Operational Expenses

Example: You had to pay to rent space in your friend's mom's kitchen to make the lemonade and wash the dishes. You also had to pay to store things in their refrigerator (warehouse space). They charge you $2.00/day to do all of this. You have to pay this even when you do NOT sell anything.

So your Operational Profit = $30.00 - $2.00 = $28.00 Operational Profit.

Quick Reference: Operational Profit = Money Collected - (Product Expenses AND Ongoing Operational Expenses)

Pre-Tax Profit: After you figure your Operational Profit, you still have other expenses. You have to pay for interest on any money that you borrowed (interest and amortization costs). Your lemonade stand is not as new today as it was yesterday. That is called depreciation, and you get to deduct that expense from the income you report on your taxes, because you will need to pay to replace that stand, eventually, if you're in business long enough.

Pre-Tax Profit = Operational Profit - Interest & Depreciation Expenses

Alternately...

Pre-Tax Profit = Total Revenue - COGS - Operational Expenses - Interest/Depreciation

Example: I referred to the lemonade stand in the above explanation. Let's say it cost $730 to build, and you will deduct this stand over two years ($2.00/day). Plus, you borrowed $500.00 from your parents, and they are charging you $1.00/day interest. So you're total Interest & Depreciation expenses are $3.00/day.

So your Pre-Tax Profit = $28.00 - $3.00 = $25.00 Pre-Tax Profit.

Quick Reference: Money Collected - (Product Expenses AND Ongoing Operational Expenses)

Net Profit: After you figure your Pre-Tax Profit (a.k.a. the bottom line or bottom line profit), you still have tax expenses. Yup! Uncle Sam taps you on the shoulder. Most children running a lemonade stand will not make enough money to be required to pay taxes, but most of us need to pay a portion of what we make in the form of taxes.

Net Profit = Pre-Tax Profit - Tax Expenses

Alternately...

Net Profit = Total Revenue - COGS - Operational Expenses - Interest/Depreciation - Taxes

Example: Let's say that you are in the 25% tax bracket.

So your Net Profit = $25.00 - $6.25 = $18.75 Net Profit (Bottom Line Profit).

Summary Comment

As you can see, not all profit is the same.

Next time someone asks you how much profit did you make, you should reply, "What TYPE of profit do you mean?"

Many people will look at you like you live on another planet, but you couldn't make a more down-to-earth response.

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