Revenue and profit - they're two similar concepts, both relating to the dollars and cents, but too often, business owners only focus on revenue.
However, a more realistic representation of how much money a business can be found by paying attention to profit.
While they go hand in hand in many ways, there are critical differences every business owner needs to understand about these metrics and why they matter. Let's break down the fundamentals.
What is Revenue?
Revenue is sometimes referred to as the "top line" of any business. Generally speaking, the term refers to all money that comes into the business.
However, revenue alone doesn’t tell the full story of how your business is performing, because it doesn’t take into account the money that is going out to cover expenses.
As an example, compare this to income versus disposable income on an individual basis. How much you make isn’t necessarily the amount of money you have to spend freely.
That being said, it’s helpful to think of revenue as a measure of the volume of your business.
What is Profit?
Profit (also called net income) is the "bottom line" of your business. It's the amount left over after all expenses, debts, and other costs are paid.
Profit is what you, as an owner, can take out as earnings or, alternatively, reinvest in your business to grow it further. It’s also a more realistic representation of how much money is available within the business.
Understanding the overall profit of the organization is important for this reason, but the profit per line is even more impactful. This will show you the profit per operation within your business.
How do Revenue and Profit Relate?
Understanding both revenue and profit is vital for a business to succeed. These metrics both contribute to the bigger picture of your financial situation, providing different but equally valuable insights to equip you to make strategic decisions about the business.
Increasing revenue is an obvious strategy for those who want to make more money. Still, it's important to understand how revenue is growing in comparison to expenses, since having a poorly structured business leads to high or increasing revenues while still seeing low or shrinking profits. If expenses are growing at the same or a higher rate than revenue, profit will be negatively impacted.
For example, let’s say you own a design company, and the cost of a software tool you use has increased, which consequently causes your cost of sales. If you are unable to pass on the increased costs to customers by raising prices, then your revenue growth may not be enough to offset the rising expenses, leading to a negative impact on prices.
So only looking at profit without any regard for expenses could be a costly mistake, as it’s equally important to monitor how much money the business is spending.
How to Get From Revenue to Profit (and How to Use the Numbers)
You can get from revenue to profit by starting with your company's gross sales (total amount invoice) and subtracting any allowances, discounts, or returns. This simple calculation will provide your overall revenue, representing the real amount of business you've done and an accurate representation of the money that came into the business.
To calculate revenue:
Gross sales - (allowances, discounts, returns) = Revenue
Once you’ve found your revenue, keep track of its trends over time to see if your business is growing or shrinking. If your revenue is declining, it could mean your business is losing customers or facing more competition. If your revenue is increasing, it could be mean your business is performing well.
It can also be used to identify areas for improvement in your business. For example, if your revenue is low, you may need to improve your marketing or sales efforts, or develop new services to appeal to your customers.
Now that you have your revenue figures, subtract the cost of goods sold. What you have left is your gross profit.
To calculate gross profit:
Revenue - Cost of Sales = Gross Profit
Once you’ve found your gross profit, you can use that number to help you adjust pricing strategies. For example, if your gross profit margins are low, you may need to increase prices
or find ways to reduce your cost of sales to increase your margins.
You can also use gross profit to help you forecast your revenue and profitability. By projecting your expected revenue and cost of sales, you can estimate your gross profit and determine if your business is on track to achieve its financial goals.
To take it a step further, you can deduct any operating expenses from the gross profit to provide operating profit or EBIT (earnings before interest and taxes.)
To calculate EBIT:
Gross Profit - Operating Expenses = EBIT (earnings before interest and taxes)
With EBIT, you can evaluate the operating performance of your business, independent of financing and tax considerations. Do this by comparing your EBIT to previous periods or industry benchmarks and identifying areas where your business is performing well or where it needs improvement.
However, it’s important to keep in mind that most small companies do not separate interest and taxes, and for many taxes aren’t included because it’s not actually an “expense”.
Finally, factor in any costs associated with interest and taxes to get the best, most accurate representation of your company's profit.
Through this process, it’s important to keep in mind that each step provides important insights that can be used to fine-tune and improve your business.
Tips for Increasing Your Business's Profit
If you're like most businesses, your goals most likely include making some changes to improve your business and increase your profits.
Luckily, there are plenty of ways to do exactly that.
Offer Additional Services to Existing Clients
You can offer additional services to existing clients. This allows you to access more revenue without taking on the extra costs of finding a new client or customer.
One of the best ways to do this is simply by listening to your client’s feedback. Doing what you can to keep and expand business relationships is vital to maintaining and expanding profitability.
Stick to the Scope of Work
While it can be tempting to go above and beyond for your clients, do your best to stick to the scope of work you agreed on and avoid doing more work than you're being paid for as much as possible.
If you realize additional time is needed to deliver (through no fault of yours), communicate with clients to ensure they understand why and ensure they are aware that additional compensation will be needed. Don’t wait until the end and surprise the client with an unexpected bill. If you make the decision to absorb the cost, make sure the customer is aware and that the incremental amount is accounted for in the invoice as a discount. You never want customers to think they are getting something for free.
Tweak Your Operations
Operational tweaks can also do wonders to improve your profits.
Building out a lead generation strategy, which will ensure a constant flow of new customers.
Make regular adjustments to pricing - raise prices when the economy requires it and demand allows it, or cut if necessary to stimulate new business. This can be accomplished in baby steps by increasing the price for new customers with more gradual price increases for existing customers (if there is sensitivity to potentially losing customers as the result of a price change).
Evaluate recurring expenses to make sure they are absolutely necessary to run the business, especially software and monthly/annual recurring subscriptions that you may forget you are paying and aren’t using.
Let Us Help You Grow Your Profit
Revenue and profit are closely linked. However, the places they differ offer vital information to your business.
If crunching your company's financial numbers gives you a headache, know you're not alone. You started your business to lean into your passion, not pore over spreadsheets and accounting software.
Still, you can't ignore them - and that's where Little Fish Accounting can step in.
Our experienced professionals will help you understand your numbers and provide financial insights to move your business forward. You can learn more about how we can help you manage your revenue and profit by visiting our services page!