Gross Profit, Net Profit, “I can’t remember which is which.”
Here’s an easy way to remember: Gross profit is the larger number. A Gross of something is a big amount: Picture 144 baby chicks hopping around… In this case, Gross means “big” not “bad.”
Net profit is the smaller number. Think of when you pour something through a net or sieve: Less comes out.
OK, so Gross Profit is found by subtracting Direct Costs from Revenues (or Sales). These numbers always appear on a company financial statement (FS) in the “Profit & Loss” or “Statement of Income” section, near the top.
For a masonry contractor, examples of Direct Costs are bricks, mortar and the labor to install them. Some Indirect Costs would be rent, phone expenses and office salaries.
You may have seen a Work In Process schedule which shows the financial status of open contracts. That is literally the same as the Gross Profit analysis but is specific for each project. (Keep this in mind when you read the cool bonding tip at the end.)
Now in order to be successful, companies need to produce a Gross Profit sufficient to cover all their indirect expenses and then yield a Net Profit (which always appears at the bottom of the page.)
As surety agents, we often see companies that are suffering from lack of work. Their projects are profitable, but they don’t have enough of them. They show a Gross Profit but cannot cover their Indirect Costs and therefore produce a Net Loss (they lose money for the year.) Maybe if they had laid off non-essential staff, closed an office or reduced other expenses, the Net Loss could have been avoided. The point here is that the contracts were performed successfully, but other expenses were not adequately managed and a Net Loss occurred.
The inspiration for this article was a FS we received that showed a negative Gross Profit. Pretty unusual. So what did it mean?
In this case the company lost a significant amount of money on one contract. The loss was so great that it exceeded all the gross profits earned on other projects resulting in a negative Gross Profit (a loss). Next comes the Indirect Expenses which resulted in a significant Net Loss.
When a negative Gross Profit is produced, it is almost impossible for a company to have a profitable year. In that case, the Gross Profit is Gross – meaning bad!
Here’s an example of what you’d see on the Statement of Income:
Statement of Income
Current Earnings – $1,000,000
Current Costs – $1,250,000
Gross Profit (Loss) – ($250,000)
General & Administrative Expenses – $75,000
Net Loss – ($325,000)
Cool Bonding Tip: The Gross Profit section of the P&L describes the accumulated results of past projects, similar to the WIP schedule which shows today’s projects individually, during their performance.
By comparing the expected GP % of incomplete jobs on the WIP schedule to last years P&L, you can predict if the new projects are likely to result in a NET profit for the upcoming year-end financial statement (assuming other factors, such as expenses and total revenues, are similar to the prior year.)
Business owners facing such circumstances should consider immediately cutting indirect expenses in a proportionate amount so a fiscal year-end net profit is more likely.
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