Revenue, expenses and profit

In simple terms

Three words describe how a business earns money.

• Revenue (also called sales or turnover) is the money earned from selling goods or services. A tea stall's revenue is the total of all cups sold.
• Expenses are the costs of running the business: ingredients, rent, salaries, electricity, interest on loans, taxes.
• Profit is what is left from revenue after expenses. If expenses are bigger than revenue, the result is a loss.

The idea is simple. The detail lies in which expenses you subtract, because profit is reported at several levels, and each level answers a different question.

Levels of profit

1. Gross profit = revenue − cost of goods sold. The cost of goods sold covers the direct costs of what was sold: raw materials, stock bought for resale, and the labour directly used to make it. Gross profit shows whether the basic business of making and selling is profitable.
2. Operating profit = gross profit − operating expenses. Operating expenses are the costs of running the business that are not tied to each unit sold: rent, office salaries, marketing, and so on. Operating profit shows how profitable the business is before considering how it is financed.
3. Net profit = operating profit − interest − tax, plus or minus any other income or one-off items. Net profit, also called profit after tax, is what belongs to the shareholders.

Margins: profit per ₹100 of sales

Rupee profits are hard to compare between businesses of different sizes. A margin solves this by dividing a profit by revenue.

For the bakery: gross margin is ₹10,80,000 ÷ ₹24,00,000 = 45%; operating margin is 20%; net margin is about 13.1%. So out of every ₹100 a customer pays, about ₹13 ends up as profit for the owner.

Margins vary a lot between industries. A supermarket might earn a few rupees of net profit per ₹100 of sales but sell huge volumes; a software company might keep far more of each ₹100. Comparing margins is most useful between similar businesses.

Why it matters

Headlines love revenue: "company crosses ₹1,000 crore in sales". But revenue is only the start of the story. A business can grow its revenue every year and still lose money every year, if its costs grow faster. Some fast-growing companies have done exactly that for years, and their shareholders' returns depend entirely on whether profits eventually arrive.

Profit is what ultimately pays dividends and makes a business more valuable. Understanding the levels of profit tells you where a business makes or loses money: in the basic product (gross), in running the business (operating), or in its financing and tax (net).

Limitations

Profit is an accounting measure, not a pile of cash. It is calculated using rules that record revenue when a sale is made, even if the customer has not paid yet, and spread some costs over several years. So a business can report a profit and still run out of money, as the next lesson, Profit compared with cash flow, explains.

Net profit can also be moved up or down by one-off items, such as selling a building or writing off a failed investment. When you compare years, check whether anything unusual is included.

Common mistakes

• Treating revenue as profit. "The company made ₹500 crore" usually means it sold ₹500 crore, not that it kept it.
• Comparing rupee profits across very different sizes. Use margins.
• Comparing margins across very different industries. A low-margin business is not necessarily a bad one.
• Ignoring one-off items. A big profit from selling land is not the same as a profitable business.
• Equating profit with cash. They can be very different.

Try it yourself

A made-up company, Konark Tiles Ltd, reports for the year: revenue ₹500 crore, cost of goods sold ₹320 crore, operating expenses ₹110 crore, interest ₹20 crore and tax ₹12 crore.

1. Calculate gross profit, operating profit and net profit.
2. Calculate the gross, operating and net margins.
3. If revenue grows 20% next year but cost of goods sold, operating expenses and interest each grow 30%, what happens to profit before tax?

Answers: gross ₹180 crore, operating ₹70 crore, net ₹38 crore; margins 36%, 14% and 7.6%. This year's profit before tax is ₹500 − ₹320 − ₹110 − ₹20 = ₹50 crore. Next year it is ₹600 − ₹416 − ₹143 − ₹26 = ₹15 crore: a 70% fall in profit despite 20% revenue growth.