The terms sales, revenues and profit are often used by the uninitiated as if they were synonymous, whereas there are important differences between them, particularly when it comes to profit and the other two terms. Some basic understanding of financial terms and concepts can be very useful for the small business owner, because a company’s success or failure is often dependent on them, even if they don’t realise it. Knowing and understanding what are the important signs when it comes to the financial health of your business can be critical.
The easiest term to define is sales which, put simply, is the income you get from selling your products and services. This figure is usually calculated net – that is to say, taking account of any customer returns or discounts that may be offered.
Sales and revenue can be the same thing if all the income generated by a company comes from what it sells. However, many companies have many other sources of income – interest, royalties, fees and dividends – which do not fall under the definition of sales, but which can still represent important sources of cash flow for a business. Although sales are sometimes referred to operating revenue and revenue as total revenue, the same differentiation applies.
Profit, on the other hand, reflects the money left over from your revenue after you have deducted the costs of running your business. Again, there is an important distinction to be made – between gross and net profit.
Gross profit is the revenue that you earn from selling a product or service, less the direct costs of producing it. These include, for example, materials consumed, advertising and marketing costs, staff involved in the production or selling activity, and other expenses involved in getting the goods or services to market. Net profit, on the other hand, takes account of all the costs associated with a company doing business, including overheads such as administrative costs, depreciation, bank and loan interest.
Not only are the differences between these terms not always understood, but their relative significance can be missed as well. High sales may be a good thing, for example, but if the cost of producing your goods or services is such that your gross profit is negative, or too low to cover your overheads, then your business is in trouble. Conversely, you may have modest sales, but if your production costs and overheads are also low, you may have a successful operation.
Once you have identified these key metrics, it is important to apply them to your own business. For example, if you forecast, based on current and forecast sales, your gross profit for the month, you should be able to estimate if you are going to generate enough money to cover your operating expenses. If you project your gross profit is not going to be enough, then you either need to promote your product or services more heavily, or offer some form of promotion to build sales.
Of course, at least in the short-term, it is often easier to cut costs than increase sales. But it is important to know which costs can be easily reduced. Accountants will often talk about variable and fixed costs, for example. A variable cost is one that changes with the level of production or sales, whilst a fixed cost is relatively constant, staying the same if one unit is sold in a month or a thousand. Whilst somewhat of a simplification, a variable costs can be reduced quickly if there is a need to cut expenses, whilst it is difficult to reduce fixed costs. For example, land and buildings usually represent long-term investments which it is hard to sell, or otherwise get off the books (via a sale and leaseback transaction, for example). On the other hand, variable costs such a advertising, promotion and travel costs can be easily cut or adjusted as demand and performance dictates.
Sales, Revenue, Gross and Net Profit are terms that entrepreneurs and small businesses should understand, as well as appreciate the difference between them. They are all related, so know what they are for your business, understand how the change in one can impact the others, and always keep these in mind before embarking on any new project or investment.