A:

For companies at every stage of development, accurately measuring profitability is crucial to the creation of effective business practices and finance management. There are numerous metrics used by businesses, accountants and financial analysts to measure profitability in different contexts; net income is the most well-known of these metrics. From startups to blue chips, every company needs to keep a close eye on the bottom line. Net income reflects the amount of revenue that remains as profit after accounting for all expenses, debt, income streams and taxes. However, while it gives a bird's eye view of profitability, sometimes the devil is in the details. For startups especially, calculating profitability at various levels is the best way to ensure optimal financial practices at every stage, paving the way for future growth.

At the most basic level, startups should assess profitability on an item-by-item basis. The goods and quantities a company produces largely determine its revenue, and without revenue, there can be no profit. Marginal revenue is the amount of increased revenue generated by each additional item produced. If a company produces one more widget than it did the week before and sells it for $10, the marginal revenue for that widget is $10. Maintaining healthy marginal revenue is crucial to ensuring a company's primary operations are not draining its finances unnecessarily. If the marginal revenue does not equal or exceed the marginal cost, there is little benefit gained by increasing output. Monitoring marginal revenue helps businesses of all sizes ensure optimal production levels.

There is a lot more to running a business than just adding up sales figures. Producing goods and services costs money before it makes money. Gross profit is a measure of profitability that accounts for the cost of creating products for sale and is calculated by subtracting the cost of goods sold, or COGS, from total revenue. COGS includes all expenses directly associated with producing goods for sale, such as the cost of raw materials, labor to create or assemble products, shipping and freight costs. If a product generates a huge amount of revenue, but costs almost as much to produce, there is little profit left over to invest in future growth. A startup with inefficient production practices will quickly find itself floundering.

At the next level, it is important to ensure day-to-day operations are not an unnecessary drain on cash flow. Operating profit measures the amount of revenue that remains after accounting for operational expenses, such as rent, utilities, wages and insurance, in addition to COGS. This metric informs business owners about the degree to which their potential profits are being eaten up by just keeping on the lights. If there is a large gap between gross profit and operating profit, it may be an indication overhead expenses are too high. Startups can use this metric to inform decisions about property location, business hours and personnel changes.

Startups can use all these profitability metrics to establish how and where they are making and losing money. From which products to sell, to how many people to employ, or how much debt to take on to fund future growth, assessing profitability at multiple levels enables business owners to make more informed decisions across the board.

RELATED FAQS
  1. What is the formula for calculating profit margins?

    Learn about gross, operating and net profit margins, how each is calculated and how they are used by businesses and investors ... Read Answer >>
  2. Gross Profit, Operating Profit and Net Income

    Find out how to calculate gross profit, operating profit, and net income. Learn about the relationships between theses types ... Read Answer >>
  3. What is considered a healthy operating profit margin?

    An operating profit margin is a profitability ratio that investors use when evaluating a company. Comparing a company's margins ... Read Answer >>
  4. How does gross margin and net margin differ?

    Gross margin or gross profit margin and net profit margin are both profitability ratios used in determining the financial ... Read Answer >>
  5. How do gross profit and gross margin differ?

    Both gross profit and gross margin measure how profitable a company is during a given period, but each shows profitability ... Read Answer >>
  6. Is operating profit the same as net income?

    Understand the difference between operating profit and net income, including how each type relates to the other and how both ... Read Answer >>
Related Articles
  1. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  2. Managing Wealth

    What’s a Good Profit Margin for a New Business?

    Surprisingly, the younger your company is, the better its numbers may look.
  3. Small Business

    5 Questions to Ask Before Investing in a Startup

    Investing in start-ups can be profitable but investors need to do their homework before diving in.
  4. Investing

    Profitability Indicator Ratios

    Learn about profit margin analysis, effective tax rate, return on assets, return on equity and return on capital employed.
  5. Tech

    #1 Country For Tech Start-Ups: U.S.A

    U.S. tech companies are receiving increased levels of investor funding. In 2014, the number of mega-deals for such ventures doubled over the previous year.
  6. Small Business

    Business Startup Costs: It's in the Details

    Don't overlook the details when starting up a business; it's the small expenses that have the potential to make or break a great idea.
  7. Small Business

    Declining Venture Capital Offset by Digital Economy

    While the amount of venture capital may be on the decline this new trend certainly does not seem to present a problem for tech startups in today's growing digital economy.
  8. Investing

    Will Tech Stocks Survive Higher Interest Rates? (AAPL, GOOG)

    Learn why large tech companies such as Apple and Google are likely to not be impacted by interest rate increases, but newer tech startups could have problems.
  9. Small Business

    Why Are Startups Going International?

    Expansion into international markets, if it occurs, is the final stage of a startup's evolution. Lately, though, the opposite has been happening; international expansion now occurs fairly early ...
RELATED TERMS
  1. Profit Margin

    Profit margin is a profitability ratios calculated as net income ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the ...
  3. Startup Capital

    Startup capital is money required to launch a new business, whether ...
  4. Economic Profit (Or Loss)

    Economic profit (or loss) is the difference between the revenue ...
  5. Cost of Revenue

    The cost of revenue is the total cost of manufacturing and delivering ...
  6. Operating Margin

    Operating margin is a measure of a company's profitability, and ...
Trading Center