Company owners, managers, bankers, and investors often talk about profits or income when discussing the financial performance of a business, but each may focus on very different numbers. While gross profits, operating income, net income and EBITDA all relate to earnings, each emphasizes a different aspect of financial performance.
We will define each term by using two sample companies in the coffee roasting business (see chart). Either company can be viewed as the better performing firm based on the earnings ratio that is selected.
Gross Profit is revenue minus the cost of making a product or selling a service. This is profit earned after direct expenses such as manufacturing labor, materials, supplies and some direct overhead costs are subtracted from revenue. These direct costs are usually referred to as Cost of Goods or Cost of Sales. Wages paid to workers who harvest, roast and package coffee beans, bag and box costs, maintenance costs, and other expenses incurred during the harvesting and packaging process might all be included in cost of goods. In our example, Company A is best, because its gross profit is $165,000 higher.
Gross Margin is calculated by dividing gross profit by revenue, and gross margin allows companies with different revenue levels to be compared. Since Company A has higher revenue, you would expect its gross profits to be higher; its 34.2% gross margin confirms that Company A earns $0.342 gross profit per revenue dollar while Company B earns only a $0.326 gross profit per revenue dollar.
An investor might consider Company A more attractive if he thinks he can significantly increase either company’s revenues, because additional revenue at Company A will generate more gross profit than at Company B. It is important, however, to know the specific costs that are included in costs of goods when making this comparison. In our example, Company B could be including expenses in its costs of goods that Company A includes in Selling, General and Administrative expenses (SG&A). For an accurate comparison, the gross margins must be calculated using similar costs.
Operating Income is gross profit less all selling, general and administrative expenses. These expenses include costs not directly related to making a product or delivering a service. Coffee manufacturers might include rent, management and sales wages, bank fees, advertising and travel expenses, accounting and legal fees, utilities, etc. as part of SG&A. Company B’s operating profit is $15,000 higher than Company A.
Operating Margin is calculated by dividing operating income by revenue. Again, operating margin provides a way to compare companies with different revenue levels to determine who performed best after most expenses are subtracted. Company B has both a higher operating profit and a better operating margin. While Company A was able to produce more profitable products during the manufacturing process (higher gross margin), they are now less profitable from an operating perspective, because their SG&A costs are higher than Company B. A bank or investor might now be more impressed with Company B, because its operating margin is 0.5% higher than Company A’s.
While no single earnings ratio can explain a business’s overall financial performance, gross profit and operating income do show total dollars earned at two different levels of a company’s operation. Gross margins and operating margins, however, are needed to make comparisons between companies with different total revenue.
In our example, when we switched from one earnings ratio to another, the most financially profitable company switched from Company A (higher gross margin) to Company B (higher operating margin). It is important, however, to know the specific costs that are included in cost of goods and SG&A to make an accurate comparison between companies.
Next month, we will use this same example to look at net income, net margin and EBITDA.