“The way to get started is to quit talking & begin doing”  Walt Disney

Profit, all you ever wanted to know – part 2

Written by Doug

Part 2: Gross Profit

In part 1 “profit and time” we looked at how time is an integral component of the measure of profit. In this article we will explore how different types of profit can be measured and what insight into your business each type can provide.

 

“The Bottom Line”

We’ve already established that a company’s profit is its excess of sales over costs. In its totality, this calculation is known as “Net Profit”. It’s also called “The Bottom Line” because quite literally it is the line at the bottom of the calculation:

SALES   X
     
COSTS   X
     
NET PROFIT   X

All the “slicing and dicing” and analysis of data won’t change this number. But this number only really tells you whether you did good, bad or something in between.

Of course, don’t forget that this number might not be a profit, it might be a loss. In this case, looking at some of the other types of profit may shed light on what has gone right or wrong.

So, from the Bottom Line, let’s go to the top.

Logically, the top is sales. In most businesses (but not all), every sale is coupled to a cost that will only occur if the sale happens. In the simplest sense, if you sell a bottle of beer to a customer, you must have bought the bottle in the first place and so the sale is inextricably linked to this cost.

Sticking with our guest house example: If we bring this concept into our guest house and apply it to selling a room, then certain costs will be directly linked to this sale. These costs might typically be:

  • STO discount to the agent
  • Credit card commission on the payment
  • Toiletries used by the guest
  • Breakfast eaten by the guest

These costs are known as the “Costs of Sale”. When deducted from room sales, a profit is calculated that is known as “Gross Profit”.

SALES   X
     
COSTS OF SALE   X
     
GROSS PROFIT   X
     
GROSS PROFIT %   %

The gross profit is a very useful profit to monitor, due to its absolute link to sales. Even better, the gross profit can be expressed as a percentage relative to its sales – known as the “Gross Profit Percentage”.

If the relationship of the costs of sale to sales always stay the same then the gross profit percentage will be the same whether you sell 1 room or 100 rooms.

Monitoring the gross profit percentage over time can be really useful in flagging changes in the sale/cost of sale relationship. For instance if you begin to receive more business via agents, rather than direct via Nightsbridge, the extra STO cost you will be paying per booking will cause the gross profit percentage to go down (ie the cost of sale becomes larger in relation to the sale).

Now, you may be happy with this trend or you may decide to limit the number of bookings from this source. Either way, the gross profit percentage has alerted you to something that may require a decision.

Conversely, you may decide to reconfigure your breakfast offering to use cheaper ingredients or cut down on wastage. Over time, if your plan is working, you should see the gross profit percentage increase as the cost of sale is reduced. If the opposite happens, its time to take another look at what is going on in the kitchen!

Another interesting feature of gross profit percentage is that it can act as a benchmark between comparable businesses. If you have multiple guest houses, their gross profit percentage should all be the same. If one has a noticeably lower percentage than the others, perhaps its time to ask some questions.

You could compare gross profit percentage with your associate across the street – provided you are happy to reveal your hand!

This practice of looking for trends in the gross profit percentage can be applied to any aspect of your business wherever there are costs directly linked to sales. The key to success is to maintain consistency in knowing which costs link to which sales and also to be patient and monitor the trends over time.

Not every cost is directly linked to an individual sale. For instance, your rates must be paid and your garden must be tended whether you are full or empty.

These kinds of cost are known as “Overheads”.

Strictly speaking, when the overheads are deducted from the gross profit, then we arrive at our old friend the bottom line.

SALES   X
     
COSTS OF SALE   X
     
GROSS PROFIT   X
     
OVERHEADS   X
     
NET PROFIT   X

In Part 3 we’ll delve into Operational Profit.

See you in Part 3

Doug

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