If you’ve been in business for yourself or you’re just starting out your business, you’ve probably heard the terms revenue and profit. Both of them mean very good things, but it’s very important to understand the differences. From a very high level, try to think of revenue as the cash your customers pay you in order for you to pay your bills. Whatever is left after that process is your profit. Before we dive into the details, I’d like you to keep these three very important items in mind.
3 Things are Absolutely True
As mentioned, revenue is the cash coming into your business from sales. Note that the term revenue is synonymous with “sales”. Secondly, profit is the money left over when you subtract all business expenses from revenues (and a loss – the opposite of profit – occurs if your business has more expenses than revenues). Lastly, you can never have a profit without revenue. Ever. There is no exception to this.
Revenue and Profit: The Differences
There are two main differences between revenue and profit. The first is the timing in which they occur, and the second is in the classification and types of each one.
Timing of Revenue and Profit
In theory, revenue occurs first. This is when your clients or customers pay you. Although profit may occur simultaneously because you have little to no expenses or already paid them, it requires math. You have to calculate revenues, and then deduct expenses, in order to determine profit (many accounting softwares do this for you). In sum, a client has to pay you first before you can calculate profit.
Classification of Revenue and Profit
Revenue is classified into two groups, accounts receivable (or “invoices“) and cash. And “profit” is grouped into three categories: gross profit, operating profit and net profit.
Revenue Classification #1 – Cash. This occurs when a customer or client pays you with cash.
Revenue Classification #2 – Accounts Receivable. A/R, also known as invoices, occur when you bill a customer and say “pay me in 30 days” for example. Your business doesn’t receive cash up front, rather, you wait to get paid. If you wait to get paid it would be helpful to learn how to find a factoring company.
Profit Category #1 – Gross Profit. This is calculated as revenue minus any costs associated with generating that revenue. For example, say a grocery distributor buys a case of Pop Tarts for $35.04, and sells them to the grocery store for $65.53 per case. The distributors gross profit is $30.49 per case ($65.53 minus $35.04 = $30.49). Now say the grocery store sells 16 boxes in the case for $5.55 each, or a total of $88.80. The grocery store’s gross margin is $23.27 ($88.80 minus $65.53) for the case. The gross profit divided by the revenue is called “gross margin”. For the grocer, the gross margin is 39.97% ($23.27 divided by $88.80). Meaning, 40% of the revenues generated from the sale of the Pop Tarts is gross profit. In sum, the gross profit is the revenue minus what it cost to generate that revenue, assuming there are no other costs involved. But usually there are.
Profit Category #2 – Operating Profit. This calculation takes into account those other costs. For example, the boxes of Pop-Tarts aren’t going to just magically appear on the shelves at the grocery store. Someone needs to put them there – that’s the labor cost. Next, the person placing the Pop Tarts on the shelves can’t work in the dark or heat, so the grocery store has lights and air conditioning – these would be utility expenses. Also, someone needs to actually ring out the Pop Tarts from the system when a customer buys them (more labor expense). So operating profit is the gross profit minus operating expenses like heating, air conditioning, electric, internet, rent, etc.
Profit Category #3 – Net Profit. This calculation is the simplest. It is operating profit minus one-time expenses, like paying your attorney for some corporate legal work, or spending $5,000 on a special marketing campaign that you know will be a one-time occurrence. Net profit is the money you “made” in your business.
Final Thoughts on Revenue and Profit
Depending on your business, it may be more relevant or important to focus on one of the profit categories more than the others. For example, if you have high gross margin but your rent and utilities are very expensive, you may want to focus on operating profit as you cut costs. Or if your gross profit margins are super thin, you may want to figure out ways to increase sales so that the actual gross profit goes up, in order to cover your expenses. Every business is different, and understanding the types of revenue and profit is necessary to grow your business.