Understanding the difference between revenue and profit is essential in understanding basic and complicated economics. Even if you don’t know exactly what these terms mean, you’ve heard the words in passing.
Profit is money in your pocket, and revenue is sales, right? While that is true sometimes, more details will help you clarify the difference and see how it is vital to your future business endeavors.
What is revenue?
Revenue is the total amount of money generated through business sales or other activities within the business. This is the total amount before any expenses are considered or deducted from those sales.
You can calculate revenue using this simple equation:
Price x quantity=revenue
Related: What Is Revenue? Here’s Everything You Need To Know and How To Calculate It
Annual recurring revenue (ARR)
A critical vein of revenue that is vital to understanding is annual recurring revenue (ARR). ARR is revenue: specifically, the expected revenue from customers annually.
This is usually determined by subscription agreements or recurring streams of revenue. ARR is most commonly found in businesses with subscriptions for that specific reason.
Understanding ARR is critical because it provides companies with a predictable revenue stream.
This helps when it comes to forecasting cash flow and planning future growth or changes in the company. ARR is also an excellent indicator of predicted return on investment (ROI) for investors.
Related: Return on Investment (ROI)
What is profit?
Profit is the total gain or loss of money that a business has. The simple equation to reach this number is:
Revenue – expenses=profit
Profit is calculated by taking away the total expenses from the total revenue. These expenses can be generated through business activity, like utilities or employee payments or through the amount generated from taxes or other technicalities.
Related: What Is Revenue? Here’s Everything You Need To Know and How To Calculate It
Gross profit is a category of profit that is important to know as a business owner. You can calculate gross profit with this equation:
Revenue – the cost of goods sold (COGS)=gross profit
Because COGS includes the costs of producing and delivering a product or service, gross profit measures a company’s profitability before deducting operating expenses.
This helps the company by breaking down the steps to finding net profit, which can reveal points of profitability weakness in the production and taxation of a business.
Operating profit is the next step in calculating net profit. It’s similar to gross profit but includes three more categories of expenses. You can calculate operating profit with this formula:
Revenue – COGS – operating expenses – depreciation – amortization=operating profit
Depreciation and amortization are two more ideas you must understand as an entrepreneur. Depreciation reduces the actual value of equipment or vehicles due to time or use.
This calculation puts a numerical value on the asset’s cost versus its operating and residual value.
Amortization refers to the value of non-tangible products like patents or trademarks. It is calculated the same way that depreciation is calculated.
Both of these methods help to spread out the cost of assets over their useful lives and provide a more accurate picture of a company’s expenses and profits.
Net profit is the final calculation determining a business’s actual profit. You can calculate net profit using this equation:
Gross profit – operating expenses – taxes
If you missed it, this is simply subtracting all expenses from revenue. This net profit indicates the total profitability of a business and is usually an attractive number for investors if it is large enough on your financial statement.
Related: 4 Ways Net Profit Margin Equals Happiness in Life
What are the critical differences between revenue and profit?
So, comparing the definitions above, revenue is simply a company’s total sales, while profit uses that number to calculate true profitability. They are calculated in different ways and used differently.
Revenue calculates sales and market share growth, while profit is more important for profitability and financial health.
Another essential thing to note is the typical fluctuation of these numbers. Revenue tends to be highly volatile since it is subject to market demand and other factors, while profit is usually more stable over time.
Where do you find revenue and profit on an income statement?
Revenue is usually reported as the first item on the income statement. This is known as the top line. Based on the period of the financial statement, it indicates only total sales from that period.
Profit is reported last on the income statement, known as the bottom line. The net profit is on the bottom line of the types of profit discussed.
Related: What Exactly Is Your Income Statement Telling You?
Why is it important to understand the difference between revenue and profit?
Fortunately, these things are not specific to the business and entrepreneurial world. Anybody with the proper knowledge and preparation can generate revenue and, in turn, profit from their financial gain. Here are just a couple of ways to do this.
One idea to understand about profit, in particular, is short and long-term profitability. A great example is investing in a very small APY, even 2% or 3%.
A business may prioritize short-term profitability by cutting costs and reducing investment, leading to higher profit in the short term.
However, this may not be sustainable in the long term as it can harm the growth and future profitability of the business.
A business may prioritize long-term profitability by investing in research and development, expanding operations and improving customer experience, even if it means lower profit in the short term.
Related: How to Value a Business: 9 Ways to Calculate a Business’s Worth
An example of revenue vs. profit
For those who learn better from examples, consider the following example to help you distinguish between revenue and profit.
A company sells t-shirts for $10 each. This past month, they sold 100 t-shirts. So, the revenue would be calculated as such:
$10 (price) x 100 (quantity)=$1000 (revenue)
So, for this past month, the total revenue was $1000. But not all $1000 can go straight into the hand of the owner.
Consider the company’s expenses. It costs the company money to make the t-shirt, rent the store and pay the employees and utilities for the building of operations. These are just a few broad examples; any company will have multiple categories of expenses.
So, if we add all those up:
$1000 (revenue) – $750 (expenses)=$250 (profit)
That leftover from the equation is your net profit. If you want to go into more detail, you can separate each kind of expense from calculating each type of profit. But in summary, the revenue in this example is $1000 and the net profit is $250.
Revenue and profit FAQs
Despite clear explanations and definitions, many questions still emerge in discussing these two principles.
1. Can you have higher profit than revenue?
No. This is a simple math question. Since profit is calculated by taking expenses from revenue, you can never have a higher profit than revenue. In math terms, you would have to have a negative amount of expenses, which wouldn’t be expenses.
2. How is revenue different from sales?
While revenue and sales are commonly interchangeable and usually identical, there is a distinction that is important to keep in mind.
Sales are a subset of revenue. As discussed, revenue is the total money that a company earns over a period of time. Sales are the amount of money a company makes from selling products or services. It refers only to the funds generated by selling goods or services.
3. What’s more important: revenue or profit?
This question all depends on your situation. When you have these two metrics and need to utilize them, understand your problem statement before trying to make those calculations.
For revenue, you can understand how your company generates income from core business activity. A high revenue generally means the company sells more, which is a positive sign for any business. However, this does not indicate financial health since expenses are not considered.
Regarding profit, this should be your indicator of financial health. Profit is the number that shows returns for investors or shareholders, which are critical parts of your company.
So profit is more important for understanding company growth and sustenance because it indicates the ability to maintain operations, investments and ROI for shareholders.
Related: Understand Profit, Cash Flow and ROI to Ensure Your Business’ Financial Health
What understanding revenue and profit can mean for your business?
It is vital to address the ethical considerations of revenue and profit generation. Businesses should strive to generate revenue and profit that benefits all stakeholders.
Short-term profit generation that exploits stakeholders or harms the environment can have negative long-term consequences for the business and the economy as a whole.
Therefore, businesses should aim to balance revenue and profit generation with social and environmental responsibility.
To those with significant monetary value, a level of responsibility comes with that wealth. Always do your best to steward your wealth in an ethically wise way.
Check out Entrepreneur’s other articles for more information about revenue, profit and other financial topics.
Source : Entrepreneur.com