In everyday conversation, many of us tend to use the words “profit” and “income” almost interchangeably. However in the world of business and finance, the two words have very different meanings. Income, of course, refers to cash that flows into your business, while profit, on the other hand, means the cash that remains from your income, after all your expenses have been accounted for. This definition really encompasses both the terms “gross profit” and “operating profit”, though there are differences between the two.
In order to understand the differences between these concepts, it may be easiest if we consider the way that they appear on a standard income statement. To do so, we need to start with the “top line”, which is going to be your gross revenue. So that we’re on the same page (sorry for the pun), that line represents all the income your company generates through selling your products or services. From that starting point, we’re going to add in additional income from various sources, and subtract out all of your various and sundry expenses, in order to get, as results, the different types of profit.
- Gross Profit
The first thing that happens to your gross revenue as we start to flesh out your income statement is backing out your Cost of Goods Sold, or COGS. This includes only the expenses that are directly related to the production of your goods. Included in this category are your raw materials expenses, as well as the actual direct costs of labor involved in building the products. Any other labor costs, will not be calculated in at this point, nor will any overhead like rent and utilities. The result, gross profit, is simply what funds are left, after you make the product, to use for your other business costs. We call this “gross profit” because it doesn’t figure in any other expenses, including your operating expenses.
- Operating Profit
As we omitted calculations involving operating expenses when we figured your gross profit, you’ve probably guessed that those will be included in what’s know as your “operating profit”. This calculation starts with the leftover income that we’ve already called gross profit. From that number, we’ll subtract all the remaining costs of doing business. These include a variety of fixed-cost expenses like rents and insurance, as well as variable cost expenses, like payroll, utilities, shipping costs, and amortization and depreciation. Operating profit gives an indication of how profitable your company is, after figuring in, just as its name suggests, all of the costs of operating the business.
- Net Profit
Before we close the subject, it’s worth mentioning that there is one more step before you close out your income statement, and that’s net profit. To arrive at this number, which is also the so-called “bottom line”, we also need to include the items that were left out of the gross profit and operating profit calculations, like interest on loans, tax payments, and any other “one-time” expenses that have been omitted so far. We’ll also add in any income from investments or any other sources besides your sales. Most people actually consider this number to be the most important measure of your company’s success, as it shows your ability to create profit for yourself and your investors.