What does my profit say about my company?
When analyzing how well a startup or company is doing, two words commonly come to mind: sales and profit.
Sales is easy to understand and explain. Simply the amount of money made by selling directly to customers, sales is a rather straightforward measurement of how well the product is selling. More customers paying, more sales. Growing sales means that the product is gaining popularity and doing well. Decreasing sales means that customers might be unhappy with the product and are moving onto better alternatives.
Profit is simply the amount of money remaining in the company after subtracting all costs from sales. Seems easy and simple enough, right? Positive profit means less costs than sales, and the company is making money. Negative profit means spending much more than what is earned, and company capital may be running out slowly.
However, profit has a little more nuance than that. Profit can reveal a lot about a startup’s product and operations, especially to investors looking for their next big investment. Let’s take a look at the definitions of the three main types of profit and see the different messages they might convey to an outside perspective.
In the top-down order as commonly seen on an income statement, the three main profits are:
Gross profit
Operating profit
Net profit
Image from CFI.
Gross profit
Definition:
Gross profit (often shown as a percentage of total sales, also called gross profit margin or gross margin) is the amount of profit your product makes based on production costs only. The formula is Total Sales — Cost of Goods Sold (COGS) = Gross Profit.
What gross profit shows:
Gross profit or gross margin shows how economically viable the product is to make and sell. To put it in even simpler terms, it shows whether or not the product makes sense to sell. Let’s look at an example.
Say we have a company selling storage boxes to customers. All production costs — materials, assembly machinery, and labor — add up to $4 per box. Customers are willing to pay $5 per box to buy the product. The gross profit would be $5 — $4 = $1 per product. The gross margin would be 0.2 or 20%. In this case, the product yields a positive gross profit. However, is this 20% gross margin good or bad?
The preferred gross margin will vary depending on product and industry. However, it probably comes with no surprise that higher gross profit is better. Theoretically, if a product has large gross margin, and the product can be scaled to hundreds of thousands of customers with minimal increase to operating costs (discussed in the next section), then there will be extremely high potential to the profits that can be made.
Operating profit
Definition:
Operating profit (also called operating profit margin or operating margin, shown as a percentage of total sales) is the amount of profit left after subtracting all of the operating costs. The formula is Gross Profit — Operating Costs = Operating Profit.
What operating profit shows:
Operating profit shows how sustainable the company operations are in selling the product. Indirectly, operating profit gives insight to how well a startup might scale. A low or negative operating profit may show that the product is costing a lot to manage, maintain, and sell.
Examples of operating cost include director salaries, administrative employee salaries, office rental costs, utilities, phone service for answering customer calls, etc. — any recurring costs (usually on a monthly basis) that does not directly go into production costs can be considered operating cost.
Operating profit usually requires analysis next to gross profit to have significant meaning. Just knowing that operating profit is negative does not reveal whether or not production costs are too high, operating costs are too high, or both. However, if we know that gross profit is positive and fairly high (meaning that the product makes good sense to produce and sell), a negative operating profit suggests that current costs in operating the company is wiping out the positive gross profit, and may point to operation inefficiencies, or in the worst case, evidence of non-scalability. This is quite significant, because instead of writing off the entire product as illogical, the problem can be traced to the operating costs and measures can be taken for correction. Proper communication of this to potential investors may also improve chances of raising funds for new startups, since investors can easily see that the product makes economic sense; only operating costs may require more in-depth attention to improve operating profit numbers.
In general, operating costs are easier to correct and optimize compared to production costs. If a product has negative gross profit to begin with, it may be much more difficult to make a case that the product actually makes sense to sell. Therefore, by extension, negative operating profit may be more forgivable, whereas negative gross profit is highly questionable.
Net profit
Definition:
Net profit (also net profit margin or net margin, shown as a percent of total sales) is the overall bottom-line of the company — the amount of money remaining after subtracting all remaining costs. These costs can include non-operating costs, such as interest on loans or corporate income tax liabilities. For many new startups, there are usually no further costs outside of COGS and operating costs, except for income tax. In Japan, the a good estimate to use for corporate income tax is 30%. Even in a year with negative net profit, the baseline income tax owed is ¥70,000.
What net profit shows:
Similar to before, the net profit by itself may not be helpful in determining where the high costs and problems may lie. Instead, the net profit gives a good picture of the startup capital increase (positive) or burn (negative) rate. In the case of negative net profit, if the current capital situation is known, a prediction can be made as to how long a company may have before a profit must be turned.
Again, negative net profit is not necessarily immediately a bad thing. For most new startups, it is inevitable to have negative net profit for the first few years. By making the case of a good gross profit margin, however, reinforces the concept that the product makes sense to sell, and with time, scalability, and proper market-fit, huge traction and sales can be gained to overcome the operating costs that may be temporarily dragging down the overall profit.
To wrap up, let’s quickly talk about how each of these profits can essentially be “controlled.” It comes down to one major concept: cost categorization.
The only profit that cannot be altered in any way, as expected, is net profit. This profit is the final bottom-line, after all costs are factored in. However, depending on how other costs are categorized into production or operating costs, it is easy to see that gross profit and operating profit may vary slightly. On paper, there are general guidelines to what constitutes as COGS or operations that most people agree on, but there is no overarching strict rule. Founders know their own product the best, and therefore are the most qualified to understand which cost falls where.
In the end, founders can achieve two major benefits:
Better understanding of their own costs, which can help them to make decisions regarding next steps in production and/or operation
Construct an advantageous picture of startup status and health to present to investors, to gain more investment opportunities and fundraising success
