Knowing the Difference Between Earnings and Profit

An old business axiom holds that it’s not what you earn, it’s what you keep. Understanding the difference between earnings and profit is crucial for new business owners to learn.

Not knowing the difference between earnings and profit is especially common among businesses that are paid at the point of sale, but don’t have to pay vendors and suppliers until later. Consider a typical restaurant business. At the end of the week, it could be swimming in cash from sales. But once rent, utilities, payroll, food supplies, insurance, and other expenses come due at the end of the month; revenues can be eaten up quickly. Many restaurants close due to a lack of understanding of the difference between earnings and profit.

What is Profit?

There’s a big difference between the money a business collects, which is known as revenue, and the money left after all expenses are paid, which is profit. For most businesses, expenses must be paid out of revenue. Whatever money is left after the business pays all of the expenses incurred to manufacture and deliver a product or service is profit.

Understanding the concept of profit margin is important for business owners. If your business collects $2,000 for the delivery of a finished product, but it cost you $1,000 in materials, labor, and overhead to manufacture that product, your profit margin would be 50 percent (1,000 divided by 2,000 equals 0.5, or 50 percent). If you reduce your material, labor, and overhead expenses to $800, your profit margin would grow to 60 percent and your profit to $1,200.

Profit margin can be taken a step further by distinguishing between gross profit and net profit. Gross profit is what’s left after you subtract the direct costs of manufacturing a product or providing a service, like materials and direct labor costs (also known as cost of goods sold) from net sales. Net profit subtracts overhead, payroll, taxes, and other business expenses to arrive at what’s often called the bottom line.

Growing Your Profit and Margins

Growing your profit margin isn’t rocket science. It requires either reducing your costs, increasing your revenue, or both. You can cut costs in many ways, such as:

1. Curb miscellaneous expenses.  Be careful not to overspend on “little” things like office supplies, overnight shipping, meals and entertainment. They can add up fast.
2. Watch raw material costs.  Ask your suppliers if there are ways you can save on raw material costs, such as by purchasing in bulk or paying invoices early and receiving a discount.
3. Barter.  Try trading with other businesses for things they need. For example, you could barter your product or service with a magazine or newspaper in exchange for a display ad.

Here are a few ways to increase your revenue:

1. Segment customers and products.  By determining what key ways your customers and products are different, you can target your product offerings and marketing efforts more tightly. This can also help you identify which of your products are stars, cash cows, question marks, and dogs so you can invest your sales and marketing resources more effectively.
2. Create ancillary products and services.  You can add these bells and whistles to existing products or services and charge extra. They should cost you little or nothing, thus adding directly to your bottom line.
3. Raise prices.  This seems obvious, but it must be done carefully, especially during tight economic times. Ideally you should offer additional value along with the higher price so customers don’t perceive it as a price increase but rather as a value add.