One of the criticisms I most often hear about accountants and accounting field personnel is how rigid and inflexible they are. Well, I’m not a neutral voice in this argument one thing I will say is there are times when that rigidity is not only required but even a bonus. The issue that brings this up is the difference between Operating Margin under and Net Profit. At the end of this article, you should be able to understand the two clearly and why they are different beyond just their names.
Why is the distinction important?
As someone who does freelance accounting and bookkeeping work, I’ve come across people who have brought their receipts and payments after about a year operating to me requesting I produce accounts for them. Nothing wrong with that. After asking them a series of questions they did not expect I go and do the work as requested. When I present the statements with a loss or a less than flattering profit they are outraged and start to question my accounting ability as their business is profitable. Invariably the problem is in their understanding of profit.
This has had many names over the years including Gross Profit, Gross Margin or just Margin. In any case, this figure is calculated by subtracting the cost of goods (or services) sold from the revenue. This is the COST OF GOODS SOLD but excludes the COST OF SELLING GOODS. So the costs subtracted here include direct material and inventory costs, transportation cost to get the goods in, production costs of services that can be directly attributed to the product. A simple test for this is whether or not the cost is impacted by the volume of goods. If the cost shares a direct and predictable relationship with goods or services it goes here. This is a top-line profit figure. It speaks to the profitability of your product but not of your business. As we are about to see these two can be very different things.
This too has many names but all ultimately mean the same thing. Net Profit, Net Margin, Bottom line profit, net income. This is derived from taking our operating profit or margin and further subtracting expenses the business incurred that cannot be directly linked to goods and or services. The best example of this is your internet bill. Whether you use mobile, fixed-line, wireless, fibre or some mix of these you will appreciate that it is very difficult to apportion a direct contribution to production. These are therefore treated as costs to the business rather than costs of goods or products sold. They range from things such as rent and electricity to salaries. There’s a bit of a grey area developing in your mind about payments for labour that is linked to product or service delivery. It’s simple, if the payment, like a commission, is directly linked to output it Is deducted in the top line, in operating margin. However, if the commission is after expenses it is deducted in calculating net profit. Expenses like advertising, transport (except to bring goods or inventory in) and business costs will also be deducted here.
The difference between the two can be the difference between thinking you are profitable or more profitable than you are, both are dangerous especially when not true. You can have a profitable product but that does not automatically make your business profitable. The smart amongst you can already see that your business is profitable when the remainder of product profit (operating margin) is sufficient to cover business expenses. If you need a simple rule to remember this operating margin is about the product and net margin is about the business.