In this post, I will answer the question that all professionals and entrepreneurs must understand in order to succeed in the world of business:
What is revenue, cost, and profit?
Through my experiences as a student of economics at the Lender School of Business and as an entrepreneur running a multi-million dollar business, I have discovered that a surprisingly large population of individuals are tripped up by revenue, cost, and profit when thinking about their life, their business, and the company that they are working for.
From my interactions with others, I have heard that revenue and profit are the same thing and that gross profit is equal to net profit. It’s easy to blend all of the different figures together when they all have different names and they are referred to in new ways depending on who you are talking to.
But who is really to blame for such a large population of people misunderstanding these figures? Is it their college professors? Maybe. What about their parents? Could they have done a better job explaining? Is it simple their own self-motivation to understand? Also possible.
Regardless of who is to blame, revenue, cost, and profit will arise at some point within your life. I argue that in order to make your personal and professional goals become a reality, you must have a strong understanding of the difference between the three.
When Revenue, Cost, and Profit Become Relevant
Whether you are managing a personal budget, interested in starting a company, currently running a business, or working for a corporation, understanding these three financial terms will place you in a better bracket to excel and impress. Let’s look at a few examples of where revenue, cost, and profit sneak their way into your life and how misunderstanding their true meaning may leave you in a state of bewilderment.
A personal budget…
It’s the new year and you’re running you want to create a personal budget to better understand where your money is going on a monthly basis. Where do you start? First, you identify the income that you are generating on a monthly basis…your revenue. Second, you create a laundry list of the items that you spend regularly write checks for. Rent, utilities, groceries, restaurants, etc…your expenses. Finally, you compare the two totals to understand if you can save any money at the end of the month…your net profit.
A new venture…
You’ve had an idea for a business for the past year and you’re finally putting the wheels in motion. You’re trying to determine how much to charge for the new skiing accessory that you’ve built and you’re running into issues with all of the numbers. Here’s what you’re looking at.
You created a relationship with a local manufacturer and they sold 100 units of the product to you for $500…your cost. For each accessory that you bought, you paid $5.00. You’ve decided that to price your product slightly below the competition, you have to sell it to the retailer at $12.00…your revenue. You compare the two numbers and get a difference of $7.00 per unit…your gross profit.
In a business, gross profit is the money that is made for the sale of the product. Revenue – Cost = Gross Profit. As opposed to your personal financial situation, businesses take other expenses like employees, technology, and overhead to continue operations. After you subtract these costs, you receive your net profit. Gross Profit – Operating Expenses = Net Profit.
A work meeting…
You have a meeting set up with a potential client for this upcoming Friday and you do some preliminary research into their company to understand how you may be able to help them. In your research, you come across a revenue figure for 2014 of $4,500,000. You stop and look at the number for a minute thinking, “Wow, if they are making that much money, they must be able to afford our digital marketing services.”
Revenue is a tricky figure when looking at it by itself. While $4,500,000 is a significant amount of money, the number is quite meaningless without knowing what it costs to create that revenue. If a business spends $4,250,000 on its employees, technology, and overhead, their net profit is really only $250,000. Quite a far ways off from $4,500,000.
If you’re ever curious about the real profit generated by a business and it is appropriate to ask, pose the question, “what are your margins?” You may get an answer like “Oh, they are around 25% before employees and overhead.” Quickly multiply $4,500,000 by 25% and you’ll learn that they are generating $1,125,000 in gross profit.
Simple Definitions for Revenue, Cost, and Profit
Now that you know where you may encounter revenue, cost, and profit in your life, I’ll provide three simple definitions to each term.
- the money that has been earned from the sale of a product or service
- the money that you pay to make the product or service
- the money that you earn after paying the cost to make the product or service
- Revenue – Cost = Gross Profit
- the money that you earn after paying any other costs associated with the sale of the product or service
- Gross Profit – (Salaries + Technology + Overhead) = Net Profit
Practice Makes Perfect!
Identify the following as either revenue, cost, or profit…
- Someone pays you $25 to mow their lawn. What is the $25 to you?
- You found out that a friend charged you $50 for a concert ticket then you found out it only cost them $40. What is the difference of $10 to your friend?
- You pay a caterer $150 to throw your friend a 30th birthday party. What’s the $150 to you?
Take note of revenue, cost, and profit as you make your way through a typical day. If you have it on your mind, you’ll realize that we are constantly coming into contact with all three.