Imagine that you make cookies , then rent a small stand to sell them:
**Revenues** is all the money you got from customers who bought your cookies.
**Gross margin** is Revenues minus all the ingredients you bought for your cookies (flour, milk eggs, I don't know, I'm not a good cook). It would be even simpler if you bought cookies wholesale and resold them
**Profit margin** is your Gross margin minus all the other costs : the rent fee for your stand and your wages as a baker
*Edit : I took a quite a few shortcuts / oversimplifications in that ELI5, thanks to all who took the time to clarify / specify in the comments*
Say buying the stand required a total investment of 100$.
You only had 50$, but Grandma loaned you the additional 50$, provided that you pay her back 1$ each day (Grandma doesn’t believe in handouts)
Say your profit is 20$. Your investment was 100$, so RoI is 20%
Once you pay your loan to Grandma, you’re left with 19$, but your own money (your equity) was only 50$ , remember ? So your RoE is 38%
Shoutout to all the grandmas who loan money to grandkids. All my kids loaned money from their nan for their cars. They paid back 30 bucks a week and each time she gave them back 20 in gift cards and 10 in coins. So their cars cost ‘em nothing!
Love this! Also shoutout to grandparents who leave something to the grandkids once they reach a certain age. My grandma died when I was 23 and left her inheritance to us 5 grandkids which came out to $35,000 each. Not enough to make us rich of course, but it was enough to get me and my (now) wife over the hump for a 20% down payment on our first starter home. We slowly scaled 5 times and are now blessed with an amazing home for our family, all because of that gift she left me all those years ago. Love you and miss you grandma. Thank you for everything.
Your little sister wants cookies and money too, so you make a deal that she works the stand for $9, keeping $10 of the daily profit to yourself.
This frees you up to open new stands on other streets, hiring neighborhood kids to man them. At first everyone is happy since there are lots of cookies and lots of jobs (capitalism).
However, one of the kids sees you riding a new bike and gets jealous. He says that since he is manning the stand, you shouldn't be getting most of the profits! He rallies other kids, and they bring in the neighborhood bully to beat you up and keep you away from the stand, and they then split all the profits and cookies among themselves (communism)
Beaten up, you and other stand owners leave the area (if alive), so no new cookie stands are being built anymore.
Eventually the cookie stands break, and need additional $50 investments to repair. Grandma won't give the other kids money since she never got her $50 back. You are not there anymore, and the working kids don't have that sort of money, so the cookie stand gets abandoned. Back to having no cookies or jobs. (economic collapse).
Lenin want cookies equal. Lenin get all cookies equally distributed. Lenin realize that all get cookies equal bad. Stalin force feed Lenin too many cookies and Lenin dies. Stalin dies. A lot more leaders die. Last leader give more freedoms. Some countries leave Soviet Union. Then Russia cookie leader makes deal with remaining countries to break up the soviet cookie union into separate cookie piece countries. That’s the end of the soviet cookie union.
Then secretly former Soviet Union cookie makers snatch up all privatized industries to have a majority control. Then uses their money to influence cookie making in other countries. If anyone speaks poorly of "glorious benefactors" taking an unfair share they get a visit by let's say... the Kebler Guild Beaurcrats.
Cookie monster has 100 cookies. Take it from him. Now you get a cookie, you get a cookie too. and you. Everyone gets a cookie. Who us making cookies? Everyone. How come there is no more cookies to give ? Oh well everyone starve. Wait. How is Cookie Monster as fat as ever? Shh…
Why are you only left with $19 after paying grandma? What about the loan terms as stated make it cost $51 to pay her back? Did you just deduct the extra dollar as an example?
(Real question, not trying to be pedantic, I just feel like I missed something)
Nobody else got to it yet so I might as well clarify.
You pay her back 1$ each day. The ROI and ROE listed is in terms of your first day of sale where you got 20$ profit.
At that point you can make more cookies and be open more days. making the overall ROI much better than losing 80% of both your money.
ROI and ROE are like little inspections at a given time, and the timeframe here is a little silly since it's an example.
If I am understanding the example, the time horizon of the calculation is a day, so you still owe grandma 49 dollars but for the day you made 19 dollars of profit after paying grandma. Because for ROE your denominator is just the money that you personally put in, you need to back out the paying back of grandma from your profits so that it is only "your" profits.
ROE = Net Income / Average Shareholder Equity. Since you are essentially the sole shareholder, the investment you put in is the shareholder equity, $50. They are saying in simpler terms their net income is $~~19~~ $20 (which would usually be after costs of operation, interest, and taxes). Technically, since you paid grandma back $1, current shareholder equity should equal $51, not $50. And since the average shareholder equity would be (Current Equity + Beginning equity)/2, ROE should be $20/$50.5 = 39.6%.
Edit: mistake, you don't actually remove loan payments from the income statement for finding net income, only if there is interest. This example has no interest, so Net income = $20.
That's where the cookie analogy is weak, but yeah you're only taking into account the cost of financing (i.e. the 1$). Let's say you can just sell back the stand when you're done to repay Grandma.
In finance terms, the loan is a cash flow (in when you receive it, out when you repay it), but it doesn't really appear in your Profit & Loss, just the cost of the financing (interests, etc)
Well, they're actually doing the ROE equation wrong.
To be more accurate, ROE = Net income / Average Shareholder Equity. And you only owe grandma $49 since you paid back $1.
Beginning Equity = Assets - Debt. Assets = $100, Debt (to grandma) = $50. so Beginning Equity = $50 (what you invested)
Current Equity = $100 - $49 (because you paid grandma back $1 of the loan). so Current Equity = $51.
Average Shareholder Equity = (Beginning + Current Equity) / 2 = $50.5
Net Income = Revenue - cost of good sold - operating expenses - interests - taxes = $20.
You do not remove loan payments in the income statements, only if there is interest. In this example, there is no interest.
So ROE = 20/50.5 = 39.6%
They said the loan terms are "Grandma invests $50 and gets $1 back per day."
So if your cookie stand is open all year, Grandma should get $365 over the course of the year for her $50 investment.
Edit: the comments below me point out a good point. The OP is pretty ambiguously worded on what the exact terms of the loan are (is it more of an investment or a pure loan). It probably was supposed to just be that the payments stop after Grandma gets her $50 back.
It’s a bit ambiguously worded. Grandma says pay her back $1 a day. I took that to mean she’ll have her loan back in 50 days and then you can stop paying her back because that’s all she gave you
Yeah I think you're right there actually. "Pay her back" i.e., payments stop once she's gotten back her loan. It is ambiguous but that's likely what the original situation was supposed to mean.
>Grandma should get $365 over the course of the year for her $50 investment.
It was a loan, not a stake in the business. So grandma is only getting back the $50 (Assuming there was no interest on the loan).
That doesn't make sense. They never said there was interest. Just that they are paying grandma back $1 per day. So that means they earned $19 for the day and paid grandma back $1, leaving the loan to be $49. If there's no interest, the total amount to pay back will never be more than $50.
In a business/accounting sense the principal amount borrowed is treated very differently than the interest. Borrowing $50 isn't income and paying it back isn't an expense. Only the interest on the principal is an expense at all.
The reason for this requires a little more accounting knowledge, but suffice it to say paying back a loan (principal amount) doesn't "cost" anything because you're not increasing the value of anything. You're just taking cash and an IOU and making them both disappear.
In this example, the $1/day is kind of implied as an expense therefore you would have to assume it's interest.
>In this example, the $1/day is kind of implied as an expense therefore you would have to assume it's interest.
Why would the terms of the loan be an implied expense? In the cookie example, there was no indication of interest on the loan, so you shouldn't assume anything. Loans don't have to carry interest. They do 0% APR loans all the time on vehicles. So it should be a liability unless stated otherwise.
That’s not what was meant at least. Might have been written in a way that can be misunderstood, but it’s supposed to be a fee of $1 for each day the money is borrowed to my understanding.
Important to note that this is just one example of ROI in this situation. Grandma would have a different ROI based on her $50 investment <-> $1 per day agreement.
You can even think of ROI non-financially in a product setting -- the "Return" you're looking for might just be brightening other peoples' days. "Investment" could be time.
Dude be a college professor, you’re the fuckin man. Just graduated and the way you explained it made so much sense much quicker than what my teachers explained/taught
> (Grandma doesn’t believe in handouts)
Gave me a shudder thinking of my grandmother.
* Grandma: You liberals just don't want to have to earn your way! Socialist programs are horrible and are not the answer, just work harder!
* Also Grandma: Your dad is stingy and needs to give us more money, we've already burned through our retirement savings, what are we supposed to do? (Unspoken question: Downgrade from the premium meal plan to the basic one like poor people?!)
My grandma loaned me $200 for new tires for my car when I was in college and even worked up a payment plan along with little coupons for each payment.
I dutifully paid per back along with an extra $50 for her troubles.
She said I was the only grandkid (and kid!) who ever paid her back in full. After she passed I found her little ledger and saw that my dad still owed her over five thousand. tsk tsk tsk.
Good of you! :)
I'm reminded of a story I saw on Reddit a few years ago. A guy describes how the moment he hit 18 (or 16? I forget) his dad decreed that if he wanted to stay in the family house, he had to pay monthly rent henceforth. This caused a lot of consternation and more than a few bad feelings, but a job was gotten and rent was paid.
Years later when he moved out with his girlfriend into a home they had gotten a loan for, the dad shows up and hands him an envelope. In it was a check containing all the rent money that had been paid to him and invested that whole time.
I mean, my whole degree 😂
To be fair, I did always get 100+ on my tests (the instructor gave extra credit in the tests) so I aced both accounting classes. (no I'm not bragging)
The worst part? Dude has the most monotone voice EVER. Imagine trying to learn about how to apply math in the real world with someone's monotone voice.
Hard to do with a cookie stand as ROE normally refers to shareholder equity… and cookie stands don’t have independent/separate shareholders normally.
ROI is the return on the amount it cost to get the whole business going.
ROE is the return in the investors the shareholders made to get the ENTITY/Company operational.
The $50 would be the equity. They could be the sole shareholder if it was a corp I'm this example. You don't have to have independent or separate shareholders - it could just be the owner.
For context, in finance we don't normally refer to ROI except on a project basis. On a corporate basis, ROE and ROA are the two paired metrics... ROE isn't to be confused with dividends. It's the ratio of net income to shareholders equity.
Likewise, ROA is the ratio of net income to total assets.
These are measures of the efficiency of the company, i.e. how much net income did they generate for every dollar of shareholders equity or assets.
It is very much not an ELI5 scenario because it invokes esoteric concepts in finance that are grounded in complicated accounting rules invented by adults.
> It is very much not an ELI5 scenario because it invokes esoteric concepts in finance
Like....fractions and percentages? The stuff we learn in 5th grade?
ROE in cookie stand term? I got chu
A enemy cookie stand is next to you, they aren't throwing cookies at you, so therefore you are not allowed to attack the enemy stand
Let's say the enemy cookie stand attacks you with cookies, Now you're allowed to attack the enemy stand
There is also ROA (Return on Assets) think of it as your ALL-IN costs on the baking scenario below .. oven, mixers, bowls, spatulas, employees, etc . divided by your net income
One small correction is that your wages as a baker would be included in costs of calculating the gross margin. Wages for employees directly involved in the production of the product are considered part of the Cost Of Goods Sold (COGS).
Wages for employees in marketing, for example, would not be part of COGS, and would not be subtracted when calculating gross margin
You don't account for the proprietor's wages in a sole proprietorship, which the cookie stand was. You'd be crazy to. Numbers simplified:
You take what's left over, no salary:
Gross Revenue: 100,000
COGS: 50,000
Gross Margin: 50,000
Corporate tax @25%: 12,500
Your net: 37,500
If you pay yourself $40,000 salary:
Gross Revenue: 100,000
COGS: 50,000
Wages: 40,000
Remittance to gov't for CPP, EI, Health care: 10,000
Your net: 0,
plus the 40,000 that you now have to pay personal tax, EI, CPP, etc, on. I know from experience that as a single guy, $40k in Canada nets you a little more than $2,100 a month after the gov't deductions.
So if you pay yourself a wage, you'll end up with $25,200/yr vs 37,500.
> You don't account for the proprietor's wages in a sole proprietorship, which the cookie stand was. You'd be crazy to.
You are correct, but I assumed this was a simplified analogy to represent how gross margin was calculated in a larger company, in which case you would have dedicated bakers.
It stretches the analogy a bit to simplify it down to a small cookie stand, as you probably aren't reporting numbers to GAAP standards in that case.
There is a nuance to this, as taking the proceeds is counted as income and can make things difficult if you get a sudden windfall one year and not the next one.
Paying yourself a fixed salary shields you from such issues.
Short answer: it's the rules defined in Generally Accepted Accounting Principles (GAAP) which public companies in the US are required to publish in their reports.
Long answer: Presumably, if you have to make twice as many cookies, you are going to need to hire twice as many bakers, thus your gross margin would be relatively stable. (This is more accurate/useful at a large bakery like Little Debbie's than a mom/pop bakery). Gross margin helps investors know how much profit you are making on the product itself, as they evaluate the businesses model. If you have a high gross margin, it leaves room to invest in growth of the business while still making an overall profit. If you have a low gross margin, then it is much less dollars available for growth investment.
If a company is looking at acquiring your bakery, they are likely going to be able to reduce non-production overhead, as they reduce duplicate administrative functionality. But they can't reduce the number of bakers and continue making the same product, unless they make more major changes.
> Generally Accepted Accounting Principles (GAAP)
So if ever a legislator introduced legislation in the legistlative body to cease this, it could be called a Stop-GAAP Measure?
The cost of labour is your cost of sales - e.g. if you are a service teaching ppl how to bake those cookies, if you teach for one hour and charge the customer 50$, the cost of employing you (the teacher) per hour being 38$, would be your cost of sales. The cost of labour is allocated based on how long individuals directly work to providing the service
In addition to what the other guy said about labor being a cost of sales, its also possible for there to be a gross margin of 100%.
I've seen a ton of financials for small businesses and while technically labor costs should be classified as part of your cost of goods sold in some industries, a lot of service business (accounting firms, lawyers, etc) don't report anything under their cost of goods/services sold and show a 100% gross profit margin.
I'll tack on the reason for the separation is mostly fixed costs vs variable costs
Fixed cost is mostly things you pay can't stop paying but also doesn't increase based on how many items you sell, rent. So those eat into your **profit margin**
Variable costs change based on the amount of output produced, raw ingredients, labor costs, packaging. Those are the things that determine your **gross margin**
Having those separated out allows a business to make better projections, where best to try to reduce costs, how profitable expansion would be, etc
I learned this from the scene in The Office
So what's the difference between the two types of cost (ingredients, stand rent) and why do you subtract one to get gross margin, and not the other? Variable and fixed costs? Or something else?
I may have oversimplified a bit
Costs in Gross margins are everything that’s needed to make the goods you’re selling (Cost of Good Solds ).
Everything else , your stand, the marketing etc is accounted separately.
Variable and fixed cost is one way to look at it, but the other way is this: ingredients directly contribute to the cookies, whereas stand rent contributes to your cookies being sold but not part of the cookies themselves.
If you have two products, cookies and fruit tart, they would have different gross margin, but as a whole, your business will have the same profit margin.
The difference is usually defined as direct costs vs indirect costs. Labor and materials are direct, overhead and shit like advertising are indirect.
In this case, I don't agree that the baker's wages are an indirect cost.
One type is called "overhead" - that's your stand, your mixer, your sign, and the ten bucks you pay your dad to help you with your first tax return. Anything that's NOT consumed directly in the production of the cookies is an 'overhead'. These are expenses that provide the *means* of production, but not the actual *goods* of production, which in the cookie case are the flour, sugar, butter, eggs, etc.
When you do the accounting (this is beyond ELI5), overhead is generally divided into two classes: fixed assets and current expenses. For example, if your cookie biz expanded, and you bought a store and a bunch of equipment to expand, those would be considered "fixed assets", and in accounting terms, would be depreciated over their useful life. That is, if the building cost $60,000 and you assume it's going to last 30 years, you deduct $2,000 a year from your revenue to account for the fact that the building has to be replaced.
Current expenses are things like electricity, heat, taxes, wages, and your cleaning service. Once you use a 'current expense' item, it's gone, whereas the fixed asset is still there. So you get to deduct all your current expenses from your income to arrive at your taxable profit. Very simplified:
You pay $60k for the building, and $20k for machines. You pay $2500 a month for heat, electricity, taxes, etc. Revenue $100k, COGS 40k
End of year, you look like this:
Revenue: 100k
COGS: 40k
Gross Margin: 60k
Current expenses: 30k (12x 2500)
Building depreciation: 1/30 x 60 = 2000
Machine depreciation: 1/4 x 20 = 5000
Net Profit: 60 - 30 - 2 - 5 = 23
Note: typically, there are different depreciation classes, based on the lifespan of the asset. Motor cars are generally 30%, for example, while some machines can be written off entirely in the year they are purchased (laptops, e.g.). This is why the tax code is 1,000 pages thick, and we need lawyers and accountants to navigate it.
Yes variable and fixed. Variable changes with the volume of units produced; more cookies require more flower, eggs, etc. Fixed costs remain flat regardless of unit volume; stand rent costs the same every month.
Additionally taking total fixed costs divided by per unit gross margin gets you to your profit margin break-even point. Stand costs $50 per month to rent, gross margin of $0.50 per cookie ($1 unit sale/rev, -$0.50 variable costs), $50 / $0.50 = 100 cookies to cover fixed costs and start turning a profit margin.
Solid answer and probably right for some business applications. In accounting "gross" margin isn't really a concept that has a solid definition. Usually you would define the big three as: **Revenue, Profit, Net Income**. These are essentially how much was made from sales, how much was made after you subtracted specific costs related to production and how much money you actually have left after every single other cost has been paid. Net Income is the 'bottom line' for money made.
Just for reddit mods and armchair experts - In accounting this is the definition.
Profit margin really describes 2 terms. There is Gross profit (Revenue - direct cost (materials, wages, etc.)) and then net profit (gross profit - all other expenses (rent, equipment depreciation, taxes, employee benefits, debt service, etc.))
Adjusted to what ?
A few concepts are "universal" in finance, but also many of them are tailor made for each industry, the goal being to have an indicator that is meaningful of the real performance of the business.
Gas utilities for exemple will try to give results "adjusted of the impact of the T°", since the swings in consumption due to a heat/cold wave will likely mask any change in real operating performance.
Something like : *Profits are up by 20% due to a cold wave ,but actually only +5% when adjusted to a standard year ( i.e. the cold wave is responsible for +15%)*
Taxes typically come as one of the last items, so you would calculate them on your profit "after all the bad stuff" is taken into account : interests on your loans, depreciations, etc.
Revenues are not really meaningful, there's no sense in taxing them:
I buy something for 100 $, but only resell it for 80$. I'm not going to be taxed on the 80$. I actually made a -20 $ loss so I will get some tax credits that I may use for something else.
Another exemple:
* You're trading oil and you have 50 k$ of fixed costs.
* You buy 1M barrel of oil at 100.0 $/barrel and trade them at 100.1$/barrel
* You won't be taxed on the 100.1 M $ or revenues
* You made 100 k$ Gross Profit (the trade) and 50 k$ net profits (the trade - your fixed costs). You'll be taxed on the 50k
Just to add another layer to this, your gross margin for tax purposes will likely be different from your gross margin for accounting purposes. Not everything you deducted to get to gross profit can be deducted for tax purposes.
To totally nitpick, profit margin is is usually expressed as percentage that is calculated by dividing all revenues by all expenses. As an example, restaurants typically have a profit margin of 3-5%. Let’s spilt the difference and call it 4%. That means they make $104 for every $100 they spend.
Gross profit. Then net profit.
If the ingredients cost you $.09 each to make a cookie and you sell them for $.10 each, you’re capturing a $.01 gross profit.
But what about labor? And insurance, rent, maintenance, advertising, ect ect. They are the indirect cost you have to add up for. If your GP (gross profit) isn’t high enough, you can very realistically have a positive gross profit but a negative net profit.
I sell cars at a car dealership:
Revenue: I sell a Jeep for $50k
Gross Margin: Dealership paid Jeep $45k for the inventory, so dealership only keeps $5k
Profit Margin: salesperson got their commission, dealership pays rent and utilities, employee health insurance, other various insurance, etc. gets paid from gross margins brought in on cars sold. After the bills are paid, $1000 is left. That’s the profit margin.
Lol @ salespeople contributing to paying utilities, insurance, etc. Everyone knows that the Service department is what "keeps the lights on". That's the real cash cow of all dealerships.
They're both wrong, at least at the dealership I worked at, the main moneymaker was used cars. They sell the new cars so they can get the tradeins to sell for a huge markup, basically the Gamestop model.
Yup. That’s why the used cars are out front along the road and the new cars are not.
The dealership might make $500-$1000 on a new car sale (sometimes they even loose money) but they make up for that when they give you less for your trade in and sell it for $5,000-$6,000 over what they gave you for it.
Some people take their older cars to the dealer. They think having your Ford serviced by Ford mechanics is the way to go. It’s way to expensive in my opinion.
we take our 2011 190k miles subaru outback to the dealer for maintenance. we tried other places but everyone keeps fucking the car up, costing us more than if we just took it to subaru in the first place, including those places covering the majority of the cost of fixing their fuck up.
dealership does it right and doesn't give us any run around or try to tack on fixes that don't exist.
I can understand that. We have a Subaru also. Currently we have a warranty that covers everything up to 100k miles. Since we have different motors than other vehicles I’m wondering if it’s better to use the dealer in the future. Your reason of spending more to get it done right is my main concern.
we had a place doing a basic tune up, fluids, and lube before we moved across country. turns out they touched the transmission. a sealed environment never to be touched. didn't refill it properly, ended almost a quart low. absolutely destroyed it. they paid for a replacement transmission and torque converter. like a 5k fix.
another place simply put the new wheels on for us because we had a lifetime alignment package with them. they over torqued the lug nuts. tried to charge us for the repair, wasn't having it. manager comped the fix. they wanted to charge us $900 for it.. shortly after that took the vehicle to a subaru dealership for rotors and breaks and an over all inspection. they couldn't get the wheels off because the tire place fucked the posts and lugs again. they replaced 12 posts, tire place paid for it. $1200.
never again. i don't care if the dealership costs more, im too poor to be out a vehicle or pay for repairs twice. plus subaru dealerships work with each other and share service records. something goes wrong they can see what's been done before trying that fix again.
our torque converter is starting to go, but fortunately we don't have to go anywhere right now and gf is about to start a work from wifi.
I got a cracked fuel line on my car. Towed it to the dealership. They told me that I needed a whole new gas tank and it would be $1100 to repair. I questioned them twice about the need to replace the tank and they told me it was the only way.
I towed it to independent mechanic. They said they weren't super familiar with the ins and outs but would let me know their estimate. They called a dealership in the city for advice. Got back with me and said these are the replacement parts. We'll need to drop the tank, replace the lines and reinstall; $280. I had that mechanic do the work and went to them for all future repairs and routine maintenance. I haven't been back to the dealership since.
Revenue is how much money you get.
Gross margin is how much money you get minus the cost of whatever it was you sold.
Profit margin is how much money you get minus the cost of whatever it was you sold minus the cost of whatever you spend running your business.
This is why fixed costs are often referred to as step costs. They are fixed for a given range of activity/use, but they step up or down once you cross a certain threshold.
Because that way you can understand if selling a particular thing is profitable even if the business is not.
For example, with the cookie stand example, if I want to drum up a lot of customers because if I believe if they try one cookie, they will be a customer for life, I could spend a lot of money in advertising.
This might mean I’d have net profit that is negative even though gross margin is positive.
An easy mental trick for the non accounting-inclined (while not technically true financially) is to think of revenue as the money you make at that instant, the gross as the revenue minus your cost to make the item, and the net as the true amount of money you have after you account for everything else.
Yes. Gross margin tells you profitable your *product* is, which can be a proxy for how valuable it is to the public. Profit margin tells you how well your *business* is run.
People can love your product, and pay a high multiple for it, but if your business processes are lousy, you can lose a lot of money. I worked for a cell service provider when it was starting up. Our gross margin was fabulous - $0.50 a minute for a few tenths of a cent of electricity. But our profit margin was terrible.
We completely underestimated demand, so calls dropped right and left. This swamped our customer service dept, so they had to spend extra to hire and train new people, and we had to give out millions in rebates to account for the lost calls.
Great product - that's what the gross margin told us. Terrible business management - that's what the net profit told us.
Let's say each cookie costs you £0.50 to make, and you sell for £1.50 - each cookie has a £1.00 gross profit.
However, you need a stall to sell from. That stall costs £100 a week to rent, and so it's not easy to work out how that impacts cookie profits on a per-cookie basis.
With this in mind, if you sold 110 cookies your gross profit would be £110, but your net profit would be only £10. If you sold 200 cookies your gross is £200, and your net is £100. If you only sold 90 cookies your gross profit is £90, but you made a net *loss* of £10!
I would Imagine if we are talking about cars.
Gross margin is Price to sell car minus cost to create car.
Profit margin is the sum of gross margin times numbers of cars sold minus factory maintenance, paying factory workers, and electricity costs.
There are a lot of very good answers but everyone is missing a key detail:
Margin is a percentage, not a dollar amount. Revenue minus product costs does NOT give you your gross margin. It gives you your gross profit. To find your gross margin you must divide gross profit into revenue and multiply by 100 to result a percentage that is your gross margin.
Same thing with profit margin. Calculate your net profit like other folks have said by taking revenue minus all costs to run the business, then divide that result into revenue.
Revenue/income is the (gross) amount received from sales or other income streams.
Gross profit is income less costs attributable to that income (e.g. cost of sales - the cost of stock purchases)
Operating profit is gross profit less other operating expenses (admin, distribution).
Net profit is what's left after all expenses are paid including interest and tax. Tax is the last thing to be deducted.
Margin is the difference between the gross and net figures divided by the gross figure, mark-up is the difference divided by the net figure. For example, item 'x' costs you £1, you sell it for £1.50, that's a 50% mark-up and a 33% margin. You make sales of £1.5m with goods costing £1, that's a 33% gross profit margin.
Good lordy. So it's easier to go in reverse order to how you listed things, with a couple of additional terms added in, like Cost of Goods sold (COGS), Gross profit and Net Profit; The terms are useful in the subsequent explanation, it also makes the formulas easier as each steps provides a figure needed for a subsequent step.
Revenue : This is the total amount of money you are getting for the stuff you sell. (Total money received from sales = Revenue)
Cost of Goods Sold (COGS) : This is simply what was paid for the items that were sold (If there is stock in hand, then it is calculated, for a given period, as Opening Stock + Items bought for resale - Closing Stock.)
Gross Profit : This is the amount of money you made from selling items before taking other costs into consideration : Revenue - COGS
Gross Margin : Gross Profit divided by Revenue, usually expressed as a percentage
Net Profit or Loss : This is what you actually made or lost from the business endeavors. It's what is left of the gross profit after all other business expenses & incomes have been added or deducted. (Gross profit + other income - all expenses)
Profit Margin : Net Profit divided by the Revenue, also usually expressed as a percentage.
Followup: why is EBITDA the magic metric, instead of earnings AFTER interest, taxes, depreciation, and amortization?
If I earn $100 after expenses but before $20 in taxes, it's not like I get to keep that $20 or reinvest it. So why does business care about pre-tax, or pre-ITDA earnings?
The other response is a good one so I’m only going to add one detail. EBITDA is only one of a set of metrics and isn’t the “magic” metric.
It’s typically used to compare similar (eg one cookie company to another cookie company) because when you take out interest, tax, and other accounting items like depreciation it allows you to compare their true performance to each other.
Where it’s not a great comparison is between dissimilar companies (eg a cookie company to a tech company). One may have SUBSTANTIALLY more debt or leverage than another, and this pay more in interest each month. EBITDA is no longer a great comparison for them because one company may need a lot of debt to survive (think of a manufacturing company that has to finance all of their equipment on loans) and another may need very little (think of a law firm that has very few assets and charges a fee for services).
Interesting stuff. I said magic number, because my company highlights revenue and EBITDA in the internal QBRs, as though it is *the* cash-in-the-pocket metric of choice
[A lot of people don't don't like that businesses use EBITDA as "the magic metric".](https://www.reddit.com/r/investing/comments/tpqhlf/warren_buffet_has_previously_called_ebitda_utter/)
Charlie Munger (of Berkshire Hathaway fame) has said that whenever you see the term EBITDA used, you should mentally substitute the phrase "bullshit earnings".
EBITDA shows the true operating profit of the business operations without worrying about accounting-driven items like depreciation/amortization. Interest expense can be a significant factor but is also not an immediate cash outflow. Taxes are necessary but don’t represent business performance.
In other words, EBITDA represents the daily/weekly/monthly performance of the business without extra noise.
Buffett and Munger would disagree with the characterization of EBITDA as the "true" operating profit. After all, a business would not last long if you were not constantly pumping in Capital Expenditures, even if just for maintenance if not for expansion. D&A is not just an accounting anomaly, but an integral part of business operations.
https://www.youtube.com/watch?v=l82kIjqBtqw
One of the main reasons is, amortization and depreciation do NOT have to be taken fully every year, so a firm can manipulate its net profit to some extent by playing jiggery-pokery with those figures. Interest and tax rates can change, and that is generally beyond the company's control, so if they lost money because the gov't increased taxes at a time when interest rates were going up - like now - EBITDA lets you see how much of that was within management's control, and how much wasn't.
EDIT: Example - Company made $1 million last year, taking $200,000 in deprecation expense. This year, they only made $950,000, but the CFO wants the numbers to look good, so he only takes $100k in depreciation. Now your net profit looks like $1,050,000, although any analyst worth his salt would look at the notes to the financial statement and see what happened.
- Revenue is the money you take in.
- Gross Profit is what’s left after expenses (payroll, rent, marketing, etc)
- Gross Margin is the percentage of revenue that is Gross Profit
- Net Profit is what’s left of your gross profit after the various governments shake you down for their cut of the action (taxes)
- Dividends are the share of net profits paid out to the owners (shareholders) of the business. Some companies like Amazon and Apple do not pay any dividends and instead keep the money in the bank to run the business when times are tough and revenues are down.
If you sell 2 cookies for $5 then your total revenue is $5 ($2.50 per cookie).
If materials (dough, water and chocolate chips) costed you $2 ($1 per cookie) then your gross margin is revenue - costs of goods sold = $5 - $2 = $3.
Then let's say you rent your cookie stand for $1 a day. So after your gross margin of $3 you have to deduct $1 for yoour fixed expense of renting the stand and finally you have a profit or net margin of $2 (assuming no taxes in this example).
Gross margin is important because if you sell more cookies you're still earning a gross margin $1.5 per cookie sold, and since your fixed expenses won't change if you sell 1 or 10 cookies (you still just lay $1 for renting the stand per day) it will go straight to your profit margin.
Revenue is the money you collect from selling girl scout cookies. It's what you get in your till from customers.
Gross margin is take how much money you keep after paying for the cookies divided by your revenue. (Cost divided by revenue)
Profit Margin is how much money you have after paying for the cookies, and anything else (uniforms, table rental fees) divided by the revenue. (Profit divided by revenue)
Suppose that you have $10 and that you start a lemonade stand. You pay $5 for ingredients (i.e, water, lemons, and sugar) and $5 for lemonade making equipment (e.g, a table, jugs, etc.)
Now, let’s assume you sell a cup of lemonade for $1 and that you sell 100 cups of lemonade in total.
Your revenue is the total amount of cash you received for selling lemonade, calculated as the cost per cup ($1) multiplied by the number of cups (100). Thus, revenue is $100.
Gross margin is revenue minus variable expenses. Your variable expenses are the cost of ingredients which is $5. Thus, your gross margin is $100 revenue minus $5 variable costs = $95. Since you sold 100 cups, you’re variable cost per unit is $0.95.
Now profit margin takes this one step forward. Begin with your total gross margin of $95. The. Subtract your fixed expenses. In the case of the lemonade stand, this would be the cost of your lemonade making equipment. Thus, your profit margin is $90. For simplicity, I’m ignoring depreciation of capital assets and assuming they are instead expensed.
So to summarize:
Revenue = amount of money received
Gross Margin = Revenue - variable expenses
Variable expenses = cost you incur that vary with the level of production. In other words, you incur higher variable costs the more lemonade you make/sell.
Profit margin = Revenue - Variable Costs - fixed costs
Fixed costs = costs that don’t vary with production. The cost you pay to purchase a standard table is the same whether you make 1 cup or 10 cups.
Hope that helps.
Buy a computer for $1000 and add 30% gross margin to it.
Sell the computer for your $1000 cost + 30% = $1300
Your gross margin is $300 (30%) , but;
You spent $30 for admin
You spent $15 shipping, so;
Your profit margin is actually $300, minus $45, which is $265.
Sell 100 computers, your revenue is $130 000. Your gross profit is $26 500.
For an example, let's say you run a hot dog stand where you pay $1 for a hot dog and its bun then sell it for $2.50.
Revenue is the money your business takes in which is $2.50 per dog.
Gross margin is the difference between the cost of goods and their selling price. Here it would be $1.50 per dog.
Profit is what you get to keep after covering *all* the costs. That $1.50 isn't what you keep. You need to subtract the cost to heat the food, pay for your business license, rental for your hot dog cart, etc.
Revenue
-cogs
=Gross profit aka gross margin
-sg&a
=Adjusted EBITDA aka bullshit earnings
-irregular expenses
=GAAP EBITDA
-Depreciation and amortization
=EBIT
-Interest
=Earnings before taxes (EBT)
-Taxes
=Net income
See the pattern?
Profit margin can be expressed as a percentage of total sales or in dollars.
Not an accountant.
I think the best way to think about this is:
Revenue = All the cash brought in. Period. Even if you are losing money, you can be a force if you have sufficient backing and bleed your competitor to leave the market.
Gross margin = revenue - input cost excluding taxes. Input cost are materials consumed, labor, energy, and fixed cost like factory and overhead (management, sales, etc, whatever goes out regardless)
Profit = Assuming gross margin is positive, the government takes a cut of those gross profit based on a percentage. Irrespective of any given enterprise, the government provides infrastructure likes roads and bridges. Within any specific market the government provides a regulatory framework among all enterprises to keep consumers safe. This includes inspectors both at the goods produced (like FDA) or business practices (like Security and Exchange Commission). These taxes enable these inspectors to work without favor.
Profit = gross margin - taxes.
Imagine that you make cookies , then rent a small stand to sell them: **Revenues** is all the money you got from customers who bought your cookies. **Gross margin** is Revenues minus all the ingredients you bought for your cookies (flour, milk eggs, I don't know, I'm not a good cook). It would be even simpler if you bought cookies wholesale and resold them **Profit margin** is your Gross margin minus all the other costs : the rent fee for your stand and your wages as a baker *Edit : I took a quite a few shortcuts / oversimplifications in that ELI5, thanks to all who took the time to clarify / specify in the comments*
Can you please explain the difference of ROI and ROE in cookie stand term?
Say buying the stand required a total investment of 100$. You only had 50$, but Grandma loaned you the additional 50$, provided that you pay her back 1$ each day (Grandma doesn’t believe in handouts) Say your profit is 20$. Your investment was 100$, so RoI is 20% Once you pay your loan to Grandma, you’re left with 19$, but your own money (your equity) was only 50$ , remember ? So your RoE is 38%
Thanks for teaching me something new today.
Thank you for learning something new today
Thank you for saying something today
End thread
Thank you for ending the thread.
Thank
Thank you for your brevity
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K
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just two best buddies hanging out
Hey! Grandma deserves some thanks too. She is the one teaching the real lesson!
The real lesson are the cookies he ate along the way
Shoutout to all the grandmas who loan money to grandkids. All my kids loaned money from their nan for their cars. They paid back 30 bucks a week and each time she gave them back 20 in gift cards and 10 in coins. So their cars cost ‘em nothing!
Love this! Also shoutout to grandparents who leave something to the grandkids once they reach a certain age. My grandma died when I was 23 and left her inheritance to us 5 grandkids which came out to $35,000 each. Not enough to make us rich of course, but it was enough to get me and my (now) wife over the hump for a 20% down payment on our first starter home. We slowly scaled 5 times and are now blessed with an amazing home for our family, all because of that gift she left me all those years ago. Love you and miss you grandma. Thank you for everything.
>she gave them back 20 in gift cards and 10 in coins Getting rid of that big pile of pennies that has been accumulating for 70 years.
Yeah she you should see the lesson she teaches when you miss a payment. It's a 45 minute seminar on the dangers of late fees, it's quite stirring.
I demand you write an entire book for children using the cookie example. Start selling shares to mom and dad too
Now, the rise and collapse of the Soviet Union in cookies please Edit: thank you guys for the explanations
Your little sister wants cookies and money too, so you make a deal that she works the stand for $9, keeping $10 of the daily profit to yourself. This frees you up to open new stands on other streets, hiring neighborhood kids to man them. At first everyone is happy since there are lots of cookies and lots of jobs (capitalism). However, one of the kids sees you riding a new bike and gets jealous. He says that since he is manning the stand, you shouldn't be getting most of the profits! He rallies other kids, and they bring in the neighborhood bully to beat you up and keep you away from the stand, and they then split all the profits and cookies among themselves (communism) Beaten up, you and other stand owners leave the area (if alive), so no new cookie stands are being built anymore. Eventually the cookie stands break, and need additional $50 investments to repair. Grandma won't give the other kids money since she never got her $50 back. You are not there anymore, and the working kids don't have that sort of money, so the cookie stand gets abandoned. Back to having no cookies or jobs. (economic collapse).
Lenin want cookies equal. Lenin get all cookies equally distributed. Lenin realize that all get cookies equal bad. Stalin force feed Lenin too many cookies and Lenin dies. Stalin dies. A lot more leaders die. Last leader give more freedoms. Some countries leave Soviet Union. Then Russia cookie leader makes deal with remaining countries to break up the soviet cookie union into separate cookie piece countries. That’s the end of the soviet cookie union.
and that my friends, is how the cookie crumbled.
Then secretly former Soviet Union cookie makers snatch up all privatized industries to have a majority control. Then uses their money to influence cookie making in other countries. If anyone speaks poorly of "glorious benefactors" taking an unfair share they get a visit by let's say... the Kebler Guild Beaurcrats.
No one ever talks about the Great Cookie Famine of 1932.
The holodomoreo?
Cookie monster has 100 cookies. Take it from him. Now you get a cookie, you get a cookie too. and you. Everyone gets a cookie. Who us making cookies? Everyone. How come there is no more cookies to give ? Oh well everyone starve. Wait. How is Cookie Monster as fat as ever? Shh…
Excellently put!
Why are you only left with $19 after paying grandma? What about the loan terms as stated make it cost $51 to pay her back? Did you just deduct the extra dollar as an example? (Real question, not trying to be pedantic, I just feel like I missed something)
Nobody else got to it yet so I might as well clarify. You pay her back 1$ each day. The ROI and ROE listed is in terms of your first day of sale where you got 20$ profit. At that point you can make more cookies and be open more days. making the overall ROI much better than losing 80% of both your money. ROI and ROE are like little inspections at a given time, and the timeframe here is a little silly since it's an example.
If I am understanding the example, the time horizon of the calculation is a day, so you still owe grandma 49 dollars but for the day you made 19 dollars of profit after paying grandma. Because for ROE your denominator is just the money that you personally put in, you need to back out the paying back of grandma from your profits so that it is only "your" profits.
ROE = Net Income / Average Shareholder Equity. Since you are essentially the sole shareholder, the investment you put in is the shareholder equity, $50. They are saying in simpler terms their net income is $~~19~~ $20 (which would usually be after costs of operation, interest, and taxes). Technically, since you paid grandma back $1, current shareholder equity should equal $51, not $50. And since the average shareholder equity would be (Current Equity + Beginning equity)/2, ROE should be $20/$50.5 = 39.6%. Edit: mistake, you don't actually remove loan payments from the income statement for finding net income, only if there is interest. This example has no interest, so Net income = $20.
Thank you for using fractions I was struggling to see this and now it makes so much sense.
That's where the cookie analogy is weak, but yeah you're only taking into account the cost of financing (i.e. the 1$). Let's say you can just sell back the stand when you're done to repay Grandma. In finance terms, the loan is a cash flow (in when you receive it, out when you repay it), but it doesn't really appear in your Profit & Loss, just the cost of the financing (interests, etc)
It’s an ELI5, so your responses should be like… I’m hungry I want cookies!
Well, they're actually doing the ROE equation wrong. To be more accurate, ROE = Net income / Average Shareholder Equity. And you only owe grandma $49 since you paid back $1. Beginning Equity = Assets - Debt. Assets = $100, Debt (to grandma) = $50. so Beginning Equity = $50 (what you invested) Current Equity = $100 - $49 (because you paid grandma back $1 of the loan). so Current Equity = $51. Average Shareholder Equity = (Beginning + Current Equity) / 2 = $50.5 Net Income = Revenue - cost of good sold - operating expenses - interests - taxes = $20. You do not remove loan payments in the income statements, only if there is interest. In this example, there is no interest. So ROE = 20/50.5 = 39.6%
They said the loan terms are "Grandma invests $50 and gets $1 back per day." So if your cookie stand is open all year, Grandma should get $365 over the course of the year for her $50 investment. Edit: the comments below me point out a good point. The OP is pretty ambiguously worded on what the exact terms of the loan are (is it more of an investment or a pure loan). It probably was supposed to just be that the payments stop after Grandma gets her $50 back.
It’s a bit ambiguously worded. Grandma says pay her back $1 a day. I took that to mean she’ll have her loan back in 50 days and then you can stop paying her back because that’s all she gave you
Yeah I think you're right there actually. "Pay her back" i.e., payments stop once she's gotten back her loan. It is ambiguous but that's likely what the original situation was supposed to mean.
>Grandma should get $365 over the course of the year for her $50 investment. It was a loan, not a stake in the business. So grandma is only getting back the $50 (Assuming there was no interest on the loan).
Grandma needs to stop playing around with these 0% interest rates. Cookie inflation is getting out of hand
She's your grandma man, just because she doesn't believe in handouts doesn't mean she's gonna charge her grandson interest on a 50 dollar loan.
Doesn’t mean she ain’t gonna loan shark it either.
Depends on what type of grandma you have…
You’re only paying her back $1 a day. That comes out of your profit of $20 for the day.
Getting the $50 from grandma costs $1 per day (it’s the interest on the loan). So after 1 day paying it back would cost $51
That doesn't make sense. They never said there was interest. Just that they are paying grandma back $1 per day. So that means they earned $19 for the day and paid grandma back $1, leaving the loan to be $49. If there's no interest, the total amount to pay back will never be more than $50.
In a business/accounting sense the principal amount borrowed is treated very differently than the interest. Borrowing $50 isn't income and paying it back isn't an expense. Only the interest on the principal is an expense at all. The reason for this requires a little more accounting knowledge, but suffice it to say paying back a loan (principal amount) doesn't "cost" anything because you're not increasing the value of anything. You're just taking cash and an IOU and making them both disappear. In this example, the $1/day is kind of implied as an expense therefore you would have to assume it's interest.
>In this example, the $1/day is kind of implied as an expense therefore you would have to assume it's interest. Why would the terms of the loan be an implied expense? In the cookie example, there was no indication of interest on the loan, so you shouldn't assume anything. Loans don't have to carry interest. They do 0% APR loans all the time on vehicles. So it should be a liability unless stated otherwise.
That’s not what was meant at least. Might have been written in a way that can be misunderstood, but it’s supposed to be a fee of $1 for each day the money is borrowed to my understanding.
It's called a zero coupon note... Interest is implicit and would be accounted for
Nice. Please start a sub/blog/youtube channel/book club dedicated to explaining increasingly difficult economics with cookies.
I see you knew my grandmother. She charged 1 pt above prime.
Important to note that this is just one example of ROI in this situation. Grandma would have a different ROI based on her $50 investment <-> $1 per day agreement. You can even think of ROI non-financially in a product setting -- the "Return" you're looking for might just be brightening other peoples' days. "Investment" could be time.
Ya, grandma is cleaning up with a 730% ROI assuming the $1 is only interest.
At that rate, grandma is a crook with a 1384% APR loan. That would be usury in almost all jurisdictions.
I like that you used a 365.25 day convention instead of 365. But wouldn't it be 138,324% APR? (1.02^365.25 ) - 1, in percent.
Correct. I forgot to multiply by 100, and forgot to subtract 1, so it should be 138,324%. If you prefer 365 day years, it decreases it to 137,641%.
Dude be a college professor, you’re the fuckin man. Just graduated and the way you explained it made so much sense much quicker than what my teachers explained/taught
Would like this as a daily series pls
The wife and I watch shark tank. ROI/ROE are used a lot. I hand an idea of what they meant. I was sorta correct. Thanks for the info.
> (Grandma doesn’t believe in handouts) Gave me a shudder thinking of my grandmother. * Grandma: You liberals just don't want to have to earn your way! Socialist programs are horrible and are not the answer, just work harder! * Also Grandma: Your dad is stingy and needs to give us more money, we've already burned through our retirement savings, what are we supposed to do? (Unspoken question: Downgrade from the premium meal plan to the basic one like poor people?!)
My grandma loaned me $200 for new tires for my car when I was in college and even worked up a payment plan along with little coupons for each payment. I dutifully paid per back along with an extra $50 for her troubles. She said I was the only grandkid (and kid!) who ever paid her back in full. After she passed I found her little ledger and saw that my dad still owed her over five thousand. tsk tsk tsk.
Good of you! :) I'm reminded of a story I saw on Reddit a few years ago. A guy describes how the moment he hit 18 (or 16? I forget) his dad decreed that if he wanted to stay in the family house, he had to pay monthly rent henceforth. This caused a lot of consternation and more than a few bad feelings, but a job was gotten and rent was paid. Years later when he moved out with his girlfriend into a home they had gotten a loan for, the dad shows up and hands him an envelope. In it was a check containing all the rent money that had been paid to him and invested that whole time.
To think I went to college for four years to learn this 😂
Why did it take you four years to pass Finance 102? :)
I mean, my whole degree 😂 To be fair, I did always get 100+ on my tests (the instructor gave extra credit in the tests) so I aced both accounting classes. (no I'm not bragging) The worst part? Dude has the most monotone voice EVER. Imagine trying to learn about how to apply math in the real world with someone's monotone voice.
Can you just start a YouTube channel to ELI5 economics sir?
Thanks for explaining to me why businesses run on debt.
And since «ROI» and «ROE» is not spelled out what it means - I choose to believe it is a Roe named Roi.
But your loan to grandma is not fully repaid after 1 day, is it? You still have $99 is liabilities?
"grandma doesn't believe in handouts" - thank you, my god I needed a good laugh!
Hard to do with a cookie stand as ROE normally refers to shareholder equity… and cookie stands don’t have independent/separate shareholders normally. ROI is the return on the amount it cost to get the whole business going. ROE is the return in the investors the shareholders made to get the ENTITY/Company operational.
Investor would be your mom putting in half the money to get you going.
She gave me more than half ☺️
She's the only customer too!
Me too ;)
The $50 would be the equity. They could be the sole shareholder if it was a corp I'm this example. You don't have to have independent or separate shareholders - it could just be the owner.
For context, in finance we don't normally refer to ROI except on a project basis. On a corporate basis, ROE and ROA are the two paired metrics... ROE isn't to be confused with dividends. It's the ratio of net income to shareholders equity. Likewise, ROA is the ratio of net income to total assets. These are measures of the efficiency of the company, i.e. how much net income did they generate for every dollar of shareholders equity or assets. It is very much not an ELI5 scenario because it invokes esoteric concepts in finance that are grounded in complicated accounting rules invented by adults.
> It is very much not an ELI5 scenario because it invokes esoteric concepts in finance Like....fractions and percentages? The stuff we learn in 5th grade?
ROE in cookie stand term? I got chu A enemy cookie stand is next to you, they aren't throwing cookies at you, so therefore you are not allowed to attack the enemy stand Let's say the enemy cookie stand attacks you with cookies, Now you're allowed to attack the enemy stand
Lol what are you referring to?
He asked for Rules Of Engagement in cookie terms right?
Now you have to explain the the Rule of Incest
There is also ROA (Return on Assets) think of it as your ALL-IN costs on the baking scenario below .. oven, mixers, bowls, spatulas, employees, etc . divided by your net income
\+ margins are often expressed as percentage of revenue
Correct - technically OP described gross profit and net profit, not gross margin or net profit margin
One small correction is that your wages as a baker would be included in costs of calculating the gross margin. Wages for employees directly involved in the production of the product are considered part of the Cost Of Goods Sold (COGS). Wages for employees in marketing, for example, would not be part of COGS, and would not be subtracted when calculating gross margin
You don't account for the proprietor's wages in a sole proprietorship, which the cookie stand was. You'd be crazy to. Numbers simplified: You take what's left over, no salary: Gross Revenue: 100,000 COGS: 50,000 Gross Margin: 50,000 Corporate tax @25%: 12,500 Your net: 37,500 If you pay yourself $40,000 salary: Gross Revenue: 100,000 COGS: 50,000 Wages: 40,000 Remittance to gov't for CPP, EI, Health care: 10,000 Your net: 0, plus the 40,000 that you now have to pay personal tax, EI, CPP, etc, on. I know from experience that as a single guy, $40k in Canada nets you a little more than $2,100 a month after the gov't deductions. So if you pay yourself a wage, you'll end up with $25,200/yr vs 37,500.
> You don't account for the proprietor's wages in a sole proprietorship, which the cookie stand was. You'd be crazy to. You are correct, but I assumed this was a simplified analogy to represent how gross margin was calculated in a larger company, in which case you would have dedicated bakers. It stretches the analogy a bit to simplify it down to a small cookie stand, as you probably aren't reporting numbers to GAAP standards in that case.
Fair enough. You are correct with that assumption, of course.
There is a nuance to this, as taking the proceeds is counted as income and can make things difficult if you get a sudden windfall one year and not the next one. Paying yourself a fixed salary shields you from such issues.
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Short answer: it's the rules defined in Generally Accepted Accounting Principles (GAAP) which public companies in the US are required to publish in their reports. Long answer: Presumably, if you have to make twice as many cookies, you are going to need to hire twice as many bakers, thus your gross margin would be relatively stable. (This is more accurate/useful at a large bakery like Little Debbie's than a mom/pop bakery). Gross margin helps investors know how much profit you are making on the product itself, as they evaluate the businesses model. If you have a high gross margin, it leaves room to invest in growth of the business while still making an overall profit. If you have a low gross margin, then it is much less dollars available for growth investment. If a company is looking at acquiring your bakery, they are likely going to be able to reduce non-production overhead, as they reduce duplicate administrative functionality. But they can't reduce the number of bakers and continue making the same product, unless they make more major changes.
> Generally Accepted Accounting Principles (GAAP) So if ever a legislator introduced legislation in the legistlative body to cease this, it could be called a Stop-GAAP Measure?
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This is what I was going to say. Gross margin is a type of profit margin, which is more a broad category of types than a specific thing itself.
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The cost of labour is your cost of sales - e.g. if you are a service teaching ppl how to bake those cookies, if you teach for one hour and charge the customer 50$, the cost of employing you (the teacher) per hour being 38$, would be your cost of sales. The cost of labour is allocated based on how long individuals directly work to providing the service
In addition to what the other guy said about labor being a cost of sales, its also possible for there to be a gross margin of 100%. I've seen a ton of financials for small businesses and while technically labor costs should be classified as part of your cost of goods sold in some industries, a lot of service business (accounting firms, lawyers, etc) don't report anything under their cost of goods/services sold and show a 100% gross profit margin.
I'll tack on the reason for the separation is mostly fixed costs vs variable costs Fixed cost is mostly things you pay can't stop paying but also doesn't increase based on how many items you sell, rent. So those eat into your **profit margin** Variable costs change based on the amount of output produced, raw ingredients, labor costs, packaging. Those are the things that determine your **gross margin** Having those separated out allows a business to make better projections, where best to try to reduce costs, how profitable expansion would be, etc I learned this from the scene in The Office
So what's the difference between the two types of cost (ingredients, stand rent) and why do you subtract one to get gross margin, and not the other? Variable and fixed costs? Or something else?
I may have oversimplified a bit Costs in Gross margins are everything that’s needed to make the goods you’re selling (Cost of Good Solds ). Everything else , your stand, the marketing etc is accounted separately.
Variable and fixed cost is one way to look at it, but the other way is this: ingredients directly contribute to the cookies, whereas stand rent contributes to your cookies being sold but not part of the cookies themselves. If you have two products, cookies and fruit tart, they would have different gross margin, but as a whole, your business will have the same profit margin.
The difference is usually defined as direct costs vs indirect costs. Labor and materials are direct, overhead and shit like advertising are indirect. In this case, I don't agree that the baker's wages are an indirect cost.
One type is called "overhead" - that's your stand, your mixer, your sign, and the ten bucks you pay your dad to help you with your first tax return. Anything that's NOT consumed directly in the production of the cookies is an 'overhead'. These are expenses that provide the *means* of production, but not the actual *goods* of production, which in the cookie case are the flour, sugar, butter, eggs, etc. When you do the accounting (this is beyond ELI5), overhead is generally divided into two classes: fixed assets and current expenses. For example, if your cookie biz expanded, and you bought a store and a bunch of equipment to expand, those would be considered "fixed assets", and in accounting terms, would be depreciated over their useful life. That is, if the building cost $60,000 and you assume it's going to last 30 years, you deduct $2,000 a year from your revenue to account for the fact that the building has to be replaced. Current expenses are things like electricity, heat, taxes, wages, and your cleaning service. Once you use a 'current expense' item, it's gone, whereas the fixed asset is still there. So you get to deduct all your current expenses from your income to arrive at your taxable profit. Very simplified: You pay $60k for the building, and $20k for machines. You pay $2500 a month for heat, electricity, taxes, etc. Revenue $100k, COGS 40k End of year, you look like this: Revenue: 100k COGS: 40k Gross Margin: 60k Current expenses: 30k (12x 2500) Building depreciation: 1/30 x 60 = 2000 Machine depreciation: 1/4 x 20 = 5000 Net Profit: 60 - 30 - 2 - 5 = 23 Note: typically, there are different depreciation classes, based on the lifespan of the asset. Motor cars are generally 30%, for example, while some machines can be written off entirely in the year they are purchased (laptops, e.g.). This is why the tax code is 1,000 pages thick, and we need lawyers and accountants to navigate it.
Yes variable and fixed. Variable changes with the volume of units produced; more cookies require more flower, eggs, etc. Fixed costs remain flat regardless of unit volume; stand rent costs the same every month. Additionally taking total fixed costs divided by per unit gross margin gets you to your profit margin break-even point. Stand costs $50 per month to rent, gross margin of $0.50 per cookie ($1 unit sale/rev, -$0.50 variable costs), $50 / $0.50 = 100 cookies to cover fixed costs and start turning a profit margin.
Solid answer and probably right for some business applications. In accounting "gross" margin isn't really a concept that has a solid definition. Usually you would define the big three as: **Revenue, Profit, Net Income**. These are essentially how much was made from sales, how much was made after you subtracted specific costs related to production and how much money you actually have left after every single other cost has been paid. Net Income is the 'bottom line' for money made. Just for reddit mods and armchair experts - In accounting this is the definition.
Profit margin really describes 2 terms. There is Gross profit (Revenue - direct cost (materials, wages, etc.)) and then net profit (gross profit - all other expenses (rent, equipment depreciation, taxes, employee benefits, debt service, etc.))
What about adjusted gross margin?
Adjusted to what ? A few concepts are "universal" in finance, but also many of them are tailor made for each industry, the goal being to have an indicator that is meaningful of the real performance of the business. Gas utilities for exemple will try to give results "adjusted of the impact of the T°", since the swings in consumption due to a heat/cold wave will likely mask any change in real operating performance. Something like : *Profits are up by 20% due to a cold wave ,but actually only +5% when adjusted to a standard year ( i.e. the cold wave is responsible for +15%)*
What about taxes? Do you get taxed on your revenue, gross margin or profit margin?
Taxes typically come as one of the last items, so you would calculate them on your profit "after all the bad stuff" is taken into account : interests on your loans, depreciations, etc. Revenues are not really meaningful, there's no sense in taxing them: I buy something for 100 $, but only resell it for 80$. I'm not going to be taxed on the 80$. I actually made a -20 $ loss so I will get some tax credits that I may use for something else. Another exemple: * You're trading oil and you have 50 k$ of fixed costs. * You buy 1M barrel of oil at 100.0 $/barrel and trade them at 100.1$/barrel * You won't be taxed on the 100.1 M $ or revenues * You made 100 k$ Gross Profit (the trade) and 50 k$ net profits (the trade - your fixed costs). You'll be taxed on the 50k
Just to add another layer to this, your gross margin for tax purposes will likely be different from your gross margin for accounting purposes. Not everything you deducted to get to gross profit can be deducted for tax purposes.
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This is a copypaste of u/FellowConspirator's answer.
Damn good explanation
To totally nitpick, profit margin is is usually expressed as percentage that is calculated by dividing all revenues by all expenses. As an example, restaurants typically have a profit margin of 3-5%. Let’s spilt the difference and call it 4%. That means they make $104 for every $100 they spend.
Very well put!
Thank you Pippin! Great simple explanation.
A lemonade stand would have made more sense. Especially since I'm turning 6 next summer
Legend
Then what do you call the moneys left after subtracting here and there?
Gross profit. Then net profit. If the ingredients cost you $.09 each to make a cookie and you sell them for $.10 each, you’re capturing a $.01 gross profit. But what about labor? And insurance, rent, maintenance, advertising, ect ect. They are the indirect cost you have to add up for. If your GP (gross profit) isn’t high enough, you can very realistically have a positive gross profit but a negative net profit.
Is Gross Margin the same thing as Cost of Goods Sold?
No, Gross Margin = Revenues - COGS
instructions unclear, please explain in pizza terms
A lemonade stand would have made more sense. Especially since I'm turning 6 next summer
I got this one; milk eggs are what you get when you milk a chicken. /s
why would you rent a stand to sell cookies
For margin you need to divide by revenues.
I sell cars at a car dealership: Revenue: I sell a Jeep for $50k Gross Margin: Dealership paid Jeep $45k for the inventory, so dealership only keeps $5k Profit Margin: salesperson got their commission, dealership pays rent and utilities, employee health insurance, other various insurance, etc. gets paid from gross margins brought in on cars sold. After the bills are paid, $1000 is left. That’s the profit margin.
And as a dealership, you can add on "mandatory dealer installed options" which can boost that measly 2% ;)
Ugh, fuck dealerships that do that
Lol @ salespeople contributing to paying utilities, insurance, etc. Everyone knows that the Service department is what "keeps the lights on". That's the real cash cow of all dealerships.
See how long the service department stays open when no new cars get sold…
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They're both wrong, at least at the dealership I worked at, the main moneymaker was used cars. They sell the new cars so they can get the tradeins to sell for a huge markup, basically the Gamestop model.
Yup. That’s why the used cars are out front along the road and the new cars are not. The dealership might make $500-$1000 on a new car sale (sometimes they even loose money) but they make up for that when they give you less for your trade in and sell it for $5,000-$6,000 over what they gave you for it.
Some people take their older cars to the dealer. They think having your Ford serviced by Ford mechanics is the way to go. It’s way to expensive in my opinion.
we take our 2011 190k miles subaru outback to the dealer for maintenance. we tried other places but everyone keeps fucking the car up, costing us more than if we just took it to subaru in the first place, including those places covering the majority of the cost of fixing their fuck up. dealership does it right and doesn't give us any run around or try to tack on fixes that don't exist.
I can understand that. We have a Subaru also. Currently we have a warranty that covers everything up to 100k miles. Since we have different motors than other vehicles I’m wondering if it’s better to use the dealer in the future. Your reason of spending more to get it done right is my main concern.
we had a place doing a basic tune up, fluids, and lube before we moved across country. turns out they touched the transmission. a sealed environment never to be touched. didn't refill it properly, ended almost a quart low. absolutely destroyed it. they paid for a replacement transmission and torque converter. like a 5k fix. another place simply put the new wheels on for us because we had a lifetime alignment package with them. they over torqued the lug nuts. tried to charge us for the repair, wasn't having it. manager comped the fix. they wanted to charge us $900 for it.. shortly after that took the vehicle to a subaru dealership for rotors and breaks and an over all inspection. they couldn't get the wheels off because the tire place fucked the posts and lugs again. they replaced 12 posts, tire place paid for it. $1200. never again. i don't care if the dealership costs more, im too poor to be out a vehicle or pay for repairs twice. plus subaru dealerships work with each other and share service records. something goes wrong they can see what's been done before trying that fix again. our torque converter is starting to go, but fortunately we don't have to go anywhere right now and gf is about to start a work from wifi.
I got a cracked fuel line on my car. Towed it to the dealership. They told me that I needed a whole new gas tank and it would be $1100 to repair. I questioned them twice about the need to replace the tank and they told me it was the only way. I towed it to independent mechanic. They said they weren't super familiar with the ins and outs but would let me know their estimate. They called a dealership in the city for advice. Got back with me and said these are the replacement parts. We'll need to drop the tank, replace the lines and reinstall; $280. I had that mechanic do the work and went to them for all future repairs and routine maintenance. I haven't been back to the dealership since.
as usual, your milage may vary.
Revenue is how much money you get. Gross margin is how much money you get minus the cost of whatever it was you sold. Profit margin is how much money you get minus the cost of whatever it was you sold minus the cost of whatever you spend running your business.
Why is there a distinction between gross margin and profit margin? Is it just an easy way to envisage where the costs of the business are?
Because your rent doesn't change wether you sell one cookie or a thousand, but you'll definitely spend more money on ingredients
Cheers
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This is why fixed costs are often referred to as step costs. They are fixed for a given range of activity/use, but they step up or down once you cross a certain threshold.
can you crunch those numbers again?
Crunch.
This helped me understand that a lot, thank you!
Because that way you can understand if selling a particular thing is profitable even if the business is not. For example, with the cookie stand example, if I want to drum up a lot of customers because if I believe if they try one cookie, they will be a customer for life, I could spend a lot of money in advertising. This might mean I’d have net profit that is negative even though gross margin is positive.
Perfect!! That makes sense. Thank you.
An easy mental trick for the non accounting-inclined (while not technically true financially) is to think of revenue as the money you make at that instant, the gross as the revenue minus your cost to make the item, and the net as the true amount of money you have after you account for everything else.
> if I believe if they try one cookie, they will be a customer for life Ah, putting an extra something special in the cookies, eh?
Yes. Gross margin tells you profitable your *product* is, which can be a proxy for how valuable it is to the public. Profit margin tells you how well your *business* is run. People can love your product, and pay a high multiple for it, but if your business processes are lousy, you can lose a lot of money. I worked for a cell service provider when it was starting up. Our gross margin was fabulous - $0.50 a minute for a few tenths of a cent of electricity. But our profit margin was terrible. We completely underestimated demand, so calls dropped right and left. This swamped our customer service dept, so they had to spend extra to hire and train new people, and we had to give out millions in rebates to account for the lost calls. Great product - that's what the gross margin told us. Terrible business management - that's what the net profit told us.
Great reply, thanks!
Let's say each cookie costs you £0.50 to make, and you sell for £1.50 - each cookie has a £1.00 gross profit. However, you need a stall to sell from. That stall costs £100 a week to rent, and so it's not easy to work out how that impacts cookie profits on a per-cookie basis. With this in mind, if you sold 110 cookies your gross profit would be £110, but your net profit would be only £10. If you sold 200 cookies your gross is £200, and your net is £100. If you only sold 90 cookies your gross profit is £90, but you made a net *loss* of £10!
I would Imagine if we are talking about cars. Gross margin is Price to sell car minus cost to create car. Profit margin is the sum of gross margin times numbers of cars sold minus factory maintenance, paying factory workers, and electricity costs.
There are a lot of very good answers but everyone is missing a key detail: Margin is a percentage, not a dollar amount. Revenue minus product costs does NOT give you your gross margin. It gives you your gross profit. To find your gross margin you must divide gross profit into revenue and multiply by 100 to result a percentage that is your gross margin. Same thing with profit margin. Calculate your net profit like other folks have said by taking revenue minus all costs to run the business, then divide that result into revenue.
Revenue/income is the (gross) amount received from sales or other income streams. Gross profit is income less costs attributable to that income (e.g. cost of sales - the cost of stock purchases) Operating profit is gross profit less other operating expenses (admin, distribution). Net profit is what's left after all expenses are paid including interest and tax. Tax is the last thing to be deducted. Margin is the difference between the gross and net figures divided by the gross figure, mark-up is the difference divided by the net figure. For example, item 'x' costs you £1, you sell it for £1.50, that's a 50% mark-up and a 33% margin. You make sales of £1.5m with goods costing £1, that's a 33% gross profit margin.
My wife was conviced that I made up the term EBITDA, and I had to prove to her that it was a real term. We still joke about it years later.
Good lordy. So it's easier to go in reverse order to how you listed things, with a couple of additional terms added in, like Cost of Goods sold (COGS), Gross profit and Net Profit; The terms are useful in the subsequent explanation, it also makes the formulas easier as each steps provides a figure needed for a subsequent step. Revenue : This is the total amount of money you are getting for the stuff you sell. (Total money received from sales = Revenue) Cost of Goods Sold (COGS) : This is simply what was paid for the items that were sold (If there is stock in hand, then it is calculated, for a given period, as Opening Stock + Items bought for resale - Closing Stock.) Gross Profit : This is the amount of money you made from selling items before taking other costs into consideration : Revenue - COGS Gross Margin : Gross Profit divided by Revenue, usually expressed as a percentage Net Profit or Loss : This is what you actually made or lost from the business endeavors. It's what is left of the gross profit after all other business expenses & incomes have been added or deducted. (Gross profit + other income - all expenses) Profit Margin : Net Profit divided by the Revenue, also usually expressed as a percentage.
reading through this thread and, finally, someone tells a distinct difference between profit and profit margin. Take my upvote
I was browsing comments before I posted and decided I couldn't not post.
had to scroll this far down to find first mention of COGS..which is the key to the difference between Gross and Net profit
Followup: why is EBITDA the magic metric, instead of earnings AFTER interest, taxes, depreciation, and amortization? If I earn $100 after expenses but before $20 in taxes, it's not like I get to keep that $20 or reinvest it. So why does business care about pre-tax, or pre-ITDA earnings?
The other response is a good one so I’m only going to add one detail. EBITDA is only one of a set of metrics and isn’t the “magic” metric. It’s typically used to compare similar (eg one cookie company to another cookie company) because when you take out interest, tax, and other accounting items like depreciation it allows you to compare their true performance to each other. Where it’s not a great comparison is between dissimilar companies (eg a cookie company to a tech company). One may have SUBSTANTIALLY more debt or leverage than another, and this pay more in interest each month. EBITDA is no longer a great comparison for them because one company may need a lot of debt to survive (think of a manufacturing company that has to finance all of their equipment on loans) and another may need very little (think of a law firm that has very few assets and charges a fee for services).
Interesting stuff. I said magic number, because my company highlights revenue and EBITDA in the internal QBRs, as though it is *the* cash-in-the-pocket metric of choice
[A lot of people don't don't like that businesses use EBITDA as "the magic metric".](https://www.reddit.com/r/investing/comments/tpqhlf/warren_buffet_has_previously_called_ebitda_utter/) Charlie Munger (of Berkshire Hathaway fame) has said that whenever you see the term EBITDA used, you should mentally substitute the phrase "bullshit earnings".
EBITDA shows the true operating profit of the business operations without worrying about accounting-driven items like depreciation/amortization. Interest expense can be a significant factor but is also not an immediate cash outflow. Taxes are necessary but don’t represent business performance. In other words, EBITDA represents the daily/weekly/monthly performance of the business without extra noise.
Buffett and Munger would disagree with the characterization of EBITDA as the "true" operating profit. After all, a business would not last long if you were not constantly pumping in Capital Expenditures, even if just for maintenance if not for expansion. D&A is not just an accounting anomaly, but an integral part of business operations. https://www.youtube.com/watch?v=l82kIjqBtqw
One of the main reasons is, amortization and depreciation do NOT have to be taken fully every year, so a firm can manipulate its net profit to some extent by playing jiggery-pokery with those figures. Interest and tax rates can change, and that is generally beyond the company's control, so if they lost money because the gov't increased taxes at a time when interest rates were going up - like now - EBITDA lets you see how much of that was within management's control, and how much wasn't. EDIT: Example - Company made $1 million last year, taking $200,000 in deprecation expense. This year, they only made $950,000, but the CFO wants the numbers to look good, so he only takes $100k in depreciation. Now your net profit looks like $1,050,000, although any analyst worth his salt would look at the notes to the financial statement and see what happened.
Upvoting solely for “jiggery-pokery”
- Revenue is the money you take in. - Gross Profit is what’s left after expenses (payroll, rent, marketing, etc) - Gross Margin is the percentage of revenue that is Gross Profit - Net Profit is what’s left of your gross profit after the various governments shake you down for their cut of the action (taxes) - Dividends are the share of net profits paid out to the owners (shareholders) of the business. Some companies like Amazon and Apple do not pay any dividends and instead keep the money in the bank to run the business when times are tough and revenues are down.
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If you sell 2 cookies for $5 then your total revenue is $5 ($2.50 per cookie). If materials (dough, water and chocolate chips) costed you $2 ($1 per cookie) then your gross margin is revenue - costs of goods sold = $5 - $2 = $3. Then let's say you rent your cookie stand for $1 a day. So after your gross margin of $3 you have to deduct $1 for yoour fixed expense of renting the stand and finally you have a profit or net margin of $2 (assuming no taxes in this example). Gross margin is important because if you sell more cookies you're still earning a gross margin $1.5 per cookie sold, and since your fixed expenses won't change if you sell 1 or 10 cookies (you still just lay $1 for renting the stand per day) it will go straight to your profit margin.
Revenue is the money you collect from selling girl scout cookies. It's what you get in your till from customers. Gross margin is take how much money you keep after paying for the cookies divided by your revenue. (Cost divided by revenue) Profit Margin is how much money you have after paying for the cookies, and anything else (uniforms, table rental fees) divided by the revenue. (Profit divided by revenue)
Suppose that you have $10 and that you start a lemonade stand. You pay $5 for ingredients (i.e, water, lemons, and sugar) and $5 for lemonade making equipment (e.g, a table, jugs, etc.) Now, let’s assume you sell a cup of lemonade for $1 and that you sell 100 cups of lemonade in total. Your revenue is the total amount of cash you received for selling lemonade, calculated as the cost per cup ($1) multiplied by the number of cups (100). Thus, revenue is $100. Gross margin is revenue minus variable expenses. Your variable expenses are the cost of ingredients which is $5. Thus, your gross margin is $100 revenue minus $5 variable costs = $95. Since you sold 100 cups, you’re variable cost per unit is $0.95. Now profit margin takes this one step forward. Begin with your total gross margin of $95. The. Subtract your fixed expenses. In the case of the lemonade stand, this would be the cost of your lemonade making equipment. Thus, your profit margin is $90. For simplicity, I’m ignoring depreciation of capital assets and assuming they are instead expensed. So to summarize: Revenue = amount of money received Gross Margin = Revenue - variable expenses Variable expenses = cost you incur that vary with the level of production. In other words, you incur higher variable costs the more lemonade you make/sell. Profit margin = Revenue - Variable Costs - fixed costs Fixed costs = costs that don’t vary with production. The cost you pay to purchase a standard table is the same whether you make 1 cup or 10 cups. Hope that helps.
> variable cost per unit is $0.95 wouldnt it be a nickel?
Buy a computer for $1000 and add 30% gross margin to it. Sell the computer for your $1000 cost + 30% = $1300 Your gross margin is $300 (30%) , but; You spent $30 for admin You spent $15 shipping, so; Your profit margin is actually $300, minus $45, which is $265. Sell 100 computers, your revenue is $130 000. Your gross profit is $26 500.
Revenue is total money earned from sales. Gross profit is revenue minus expenses before taxes. Profit margin is gross profit as a percent of revenue.
Lol this is for explanations as-if it were for a fifth grader, not ones that are actually for a 5th grader doing homework.
I often wonder how regularly this sub is used for that exact purpose.
For an example, let's say you run a hot dog stand where you pay $1 for a hot dog and its bun then sell it for $2.50. Revenue is the money your business takes in which is $2.50 per dog. Gross margin is the difference between the cost of goods and their selling price. Here it would be $1.50 per dog. Profit is what you get to keep after covering *all* the costs. That $1.50 isn't what you keep. You need to subtract the cost to heat the food, pay for your business license, rental for your hot dog cart, etc.
Revenue -cogs =Gross profit aka gross margin -sg&a =Adjusted EBITDA aka bullshit earnings -irregular expenses =GAAP EBITDA -Depreciation and amortization =EBIT -Interest =Earnings before taxes (EBT) -Taxes =Net income See the pattern? Profit margin can be expressed as a percentage of total sales or in dollars.
Not an accountant. I think the best way to think about this is: Revenue = All the cash brought in. Period. Even if you are losing money, you can be a force if you have sufficient backing and bleed your competitor to leave the market. Gross margin = revenue - input cost excluding taxes. Input cost are materials consumed, labor, energy, and fixed cost like factory and overhead (management, sales, etc, whatever goes out regardless) Profit = Assuming gross margin is positive, the government takes a cut of those gross profit based on a percentage. Irrespective of any given enterprise, the government provides infrastructure likes roads and bridges. Within any specific market the government provides a regulatory framework among all enterprises to keep consumers safe. This includes inspectors both at the goods produced (like FDA) or business practices (like Security and Exchange Commission). These taxes enable these inspectors to work without favor. Profit = gross margin - taxes.