Back to basics: from sales to profit

The purpose of a for-profit business of any size is to make profit. However, when people say that the company is making money or that an investment has a good return, they often mean different things. And sometimes they don’t even have profit in mind. So, let’s look how a company transforms sales into profit by defining revenues, cost of sales, and operating expenses.

First of all, sales are not sales. There are gross sales, which represent unit sales of products or services at list or gross price. This list price represents the price that a company may publish in its official price list. Most of the time, however, companies offer discounts off these list prices.

Discounts may include negotiated discounts with specific customers, which are then offered anytime to these customers as long as the negotiated contract is in place. Discounts may also include time- or deal-limited price reductions offered as part of a promotion activity. Some companies that use distribution partners to sell their products classify also costs associated with supporting these distribution partners as discounts.

Gross sales minus discounts lead to net sales or net revenues. Net revenues represent the money that the company receives from its customers.

Net revenues = gross sales – discounts = units * list price – discounts

Second, all of the products or services that are sold to customers need to be produced and delivered, which creates cost. This cost of sales (COS) is obvious in a manufacturing environment: all the materials and parts that are needed to assemble the product plus the people assembling it plus the manufacturing facility are all part of COS. In a service business cost of sales may not be obvious, but delivering the service usually requires people providing the service to customers. The cost of these employees represents COS in a service business.

Once all costs of sales are accounted for, they are subtracted from net sales to calculate gross margin or gross profit. Sometimes gross margin percentages, which are gross margins as percentage of net revenues, are used to compare companies in an industry to determine how efficient their operations are.

Gross margin = net revenues – cost of sales

Third, every company incurs costs associated with operating the business. These costs are called operating expenses. Operating expenses are usually divided in engineering expenses or research & development (R&D), marketing and sales expenses, and other expenses. Other expenses can include administrative expenses that are not accounted for anywhere else or allocations from headquarters in large organizations.

When subtracting operating expenses from gross margin we arrive at operating income or operating profit.

Operating income = gross margin – operating expenses

Most companies pay taxes. Taxes are based on the operating income the company achieves and are usually a percentage of the operating income. When subtracting taxes from operating income we get finally to net income or net profit. This net income is at the end the measure that can be used when talking about “making money”.

Net income = operating income – taxes
= units * list price – discounts – cost of sales – operating expenses – taxes

What we have reviewed here is the income statement or profit & loss statement (P&L). This statement is an important document describing the profitability of the company. It is used mostly for accounting and taxation purposes. For investment purposes, however, it is more appropriate to evaluate cash flows, which may differ from the measures described here. But on cash flows and why cash is king at some other time.

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