Master Profit Management by Mastering the Three Levels of Profitability

A business either earns a profit on every dollar sold or they don’t.  The profits in every business are what’s left over after expenses are deducted from Net Sales.  The business profit equation is Net Sales minus expenses equals Net Income or Net Profits.

Whenever a business fails to earn a profit, it’s reflected in the P&L Statement as a negative number.  Negative profits are always a problem, and they are particularly business-threatening when they involve negative Gross Profit.

Understanding how a business earns a profit is best achieved through an understanding of the three levels of business profitability as reported on their P&L Statement and how you influence each profit level.  Below is the structure of a standard Profit and Loss Statement, also called an Income Statement:

The most important number on the P&L Statement is the bottom line number representing how much money was left over from the sales made.  The size of your profit or loss is proportionate to the amount sold and the costs incurred to deliver those sales.  This is how revenue affects profits, particularly profit dollars.

For example, if you want to earn $100,000 in Net Profit, you have to sell $1,000,000 with a Net Income percent of Net Sales of 10% or sell $500,000 with a 20% Net Income percent of Net Sales to earn the same amount.  If this is your goal, the question becomes whether it’s easier to earn a million in sales with a 10% return on sales or half a million at 20% to get your $100,000 in bottom-line profits.

Understanding how a business makes money makes making this strategic decision easier.  Your P&L Statement shows the three levels of business profitability: Gross Profit at Level One, Operating Income at Level Two, and Net Income at Level Three.

Profit Management begins with the first level of business profit—Gross Profit.

Gross Profit measures your first level of profit contribution that comes from transforming a dollar of sales into a profit.  A strong net income number is impossible without a strong gross profit in your business operations.

Gross profit is calculated by subtracting the direct costs incurred to produce a product, complete a job, or deliver services from Net Sales.  Your gross profit percent is the best determiner of how efficiently your operations convert sales into profits.

If your percent of gross profit earned on every dollar sold isn’t improving noticeably year over year, your business operations aren’t becoming more efficient. Continuously improving gross profit is the best reflection of a well-managed business.

An unhealthy gross profit results in a continuous struggle to keep sales greater than the cost of production.  If sales are not greater than COGS, money will never be left over to pay operating expenses and provide the owner with profits.

The most efficient way to increase Gross Profit is to hold direct costs while increasing selling prices. Higher prices drop straight down to the bottom line as long as there isn’t a corresponding increase in business costs to justify the higher prices. The other option is to reduce direct costs as a percentage of sales. The lower cost of goods sold will produce higher Gross Profits because you deliver your sales at a lower cost.

The second level of Profit Management—Operating Income.

Your second most important number from your P&L Statement measures what it cost you to support your operations out of every dollar of Gross Profit earned.  Operating Income or EBITDA earnings are calculated from the company’s Gross Profit, less SG&A, or overhead expenses.  EBITDA is a financial term for Earnings Before Interest Taxes Depreciation and Amortization.

The profit view reflected in EBITDA earnings is used to determine how profitable a company is concerning operations, and it’s a more accurate picture of a company’s success than Gross Sales, Gross Profit, or Net Income.  This profit number represents the income or profit resulting from your primary business operations, excluding interest, taxes, depreciation, amortization, extraordinary expenses, and other income.

The most efficient and effective way to increase Operating Income is to generate a higher Gross Profit.  Earning a higher Operating Income by reducing overhead costs will increase your operating profits and is always a smart move when you have overhead expenses that aren’t contributing to higher sales and more efficient operations.  For most established businesses, this is the first area to attack for making more money, given how easy it is to add low to no contributing fixed costs to a business.

Ultimately, Profit Management comes down to the third level of business profit—Net Income.

In any accounting period, Net Income is the end financial result. Net Income is the Bottom Line of the P&L Statement; after all, expenses are deducted from net revenues earned during that same period.   It is the only number that transfers from your P&L Statement to your Balance Sheet.  Yet, it’s your third profit level, because it is a “lagging number,” generated after every expense has been deducted from Net Sales.

Net Income represents your business’s profit after employees, suppliers, lenders, and the government has all been paid—the amount left over goes to the business owner(s) in return for the capital they put at risk to produce this income. Net Income is also called earnings, net earnings, or net profit.  When it’s a negative number that is typically referred to as the Net Loss that establishes how much was lost in the reported accounting period.

Net income is the owners’ return from operations representing either an increase or decrease in the value of their business investment based on the financial results reported on their P&L Statement.  The goal is to hold onto more than you spend on each dollar sold.  Do this, and you are earning profits.  If the business is operating at a loss, this number represents excess business spending in that accounting period.  A Net Loss represents the amount of money the business owners have to put back into the business to cover the overspend made to generate sales.

Net Income is the hardest number to impact given its high reliance on sales and operations results reflected in Gross Profit and business admin that shapes Operating Income. Again, the most business-sustaining method of increasing the bottom line is to increase Gross Profit while not wasting money on overhead.

The other way to increase Net income is through Nonoperating Income also referred to as Other Income representing any inflow of monies from earnings or payments received that is not directly attributable to the company’s core business operations.  Nonoperating income usually does not occur on an ongoing basis making it next to impossible to rely on as a lever for increasing Net Income.

Take the BusinessCPR™ Business Assessment to learn how healthy your profits are.

If your profits are shrinking and you struggle to hold onto cash, take the “free” BusinessCPR™ Business Assessment to learn how healthy your business is.  Click here

to take this no-obligation business fitness test.  Upon completing the business diagnostic, you will receive a risk profile showing how likely your business is to suffer cash flow and profit problems, the primary cause of business cardiac arrest over the next three years.

The ultimate measure of business performance is how well a business extracts profits from its sales through its operations.  Measures, indicators, and metrics are how you confirm how well your business does this through your profit quality.

The quality of your profits matters because making money is hard to do.  You make it more complicated than it already is to do when you run your business without having minimum sales and profit targets to be realized each month to establish what profit quality looks like:

1. Net sales
2. Gross Profit
3. Operating Profit
4. Net Income

When you confirm profit quality, you confirm how your business is doing while identifying where you are performing better or worse than your desired plan.  Those who understand this are those who consistently make more money than others because they know with certainty how their business earns a profit.