What is Net Profit?
Net profit is the amount left after deducting all expenses from total revenue in a given period. It varies by industry and management practices and is often called net income, net earnings, or the bottom line. These terms may slightly differ based on their placement on financial statements.
The Formula for Net Profit
Why is Net Profit important?
- Net profit is a critical metric for business owners to understand as it points to the financial health of an organization. Loss-making businesses can assess if the losses are sustainable and for how long. In comparison, the ones making profits can plan how to grow the business further. You can use it for your marketing budget or hiring more people.
- Investors are also keen on an organization’s net income as it tells them whether they will likely get a return on their investment. If a company’s net profit is consistently positive, it’s more likely to attract investors.
- Also, lenders use the net profit values to determine if an organization will repay a loan amount—higher net profits place it in a more favorable position with banks and other lending institutions. In addition, comparing your net profit to the previous period lets you know if things in the company are okay.
- Net profit margin also points to the overall management of the company’s resources. A poorly managed business will not record a high net profit and vice versa. Sound management practices of inventory and expenses substantially contribute to its growth or downfall.
Boosting Net Profit – The 50/30/20 Rule
The 50/30/20 rule for business owners is a method that helps balance direct costs, overhead, and profits.
Every business is different, and the ratio can be adjusted to fit your industry, but we’ve found that this approach consistently helps owners set a benchmark goal to steer their business toward profitability.
1. Cost of Sales (50%)
Cost of Sales, also known as Cost of Goods Sold (COGS), includes all direct costs tied to producing your product or service. For service-based businesses, labor is usually the largest expense, while product-based businesses will focus on materials and supplies.
The goal is to keep these costs at or below 50% of revenue.
COGS components include: Raw materials and supplies; Direct labor costs (e.g., project labor in a marketing agency, not office staff); Facility costs for production; Shipping and logistics; Packaging
If these costs exceed 50%, consider the following:
– Supplier Negotiations: Regularly renegotiate contracts for better pricing or bulk discounts if storage is affordable.
– Process Improvements: Apply lean manufacturing principles to minimize waste and inefficiency.
– Technology Integration: Use automation to streamline tasks and reduce labor costs, especially in service businesses.
– Outsourcing: Outsourcing where it’s more cost-effective, such as using a virtual assistant instead of a full-time employee.
2. Overhead Costs (30%) – Sales, Marketing, G&A
Overhead costs include indirect expenses essential for running the business but not directly related to production.
Overhead components include Rent or mortgage for office space; Utilities (electricity, internet, etc.); Salaries and benefits for non-production staff; Office supplies and non-direct tech services; Marketing and advertising; Insurance
To optimize these costs:
– Budgeting: Create a budget to ensure overhead stays around the 30% mark, but don’t over-focus on these costs.
– Cost-Benefit Analysis: Assess the ROI of overhead expenses, especially in marketing.
– Outsourcing and Contracting: Consider outsourcing non-core functions like payroll or IT.
3. Profit Margin (20%)
A 20% profit margin is a healthy target for most businesses after the owner has been paid.
Net Operating Profit is the revenue minus the cost of sales and overhead, resulting in income before taxes and deductions.
Key Strategies for Achieving the 50/30/20 Rule:
– Revenue Growth: Increase prices or sales volume. Many businesses underprice due to comparisons with competitors. Focus on your unique selling proposition.
– Cost Control: Keep a close eye on COGS and overhead to preserve profit margins, with an emphasis on COGS.
– Efficiency Improvements: Invest in technology, outsourcing, and streamlined processes to boost productivity and reduce waste.