I'm always fascinated by the fact that more attention seems to be paid to gross profit than to net profit. For those of you who are still fuzzy on the difference, here's a quick review.
Total sales is the amount of money you collect for the projects you build (although some may call it "income" or "revenue" or "volume"). From this amount, two types of expenses must be paid. The first are type above-the-line expenses, which are also called "cost of goods sold" or "job costs." These include everything it takes for you to build out a project—materials, labor, subcontractors, equipment, and expenses for other items consumed by the work.
If you subtract what it costs you to build your jobs from what you charge for them, the result is called gross profit. From this amount, below-the-line expenses—also called "overhead"—are paid. These consist of all of the costs associated with running your business. When you subtract these costs of doing business from gross profit, the result is called net profit. That's the amount you have actually earned after all of the bills are paid.
Crossing the Line
Now here's the interesting part. Suppose that Company A and Company B each sells $750,000 in a given year. If you could take a look at Company A's accounting setup, you would see that it has materials, subcontractors, wages, and payroll taxes posted above the line in cost of goods sold. However, health insurance and workers' comp costs are posted below the line in overhead expense accounts. By contrast, if you could look at Company B's accounting setup, you would see that while it, too, has materials, subcontractors, wages, and payroll taxes posted above the line, it has also included workers' comp, cellphones, and truck expenses in its job costs.
When it comes time to look at a profit-and-loss statement for each company (see table, below), it looks bad for Company B. Both companies spent a total of $675,000 running their businesses, but Company B appears to have a gross profit that is 13% lower than that of Company A. However, net profit for both companies is the same. The difference lies in the way that each company chose to distribute its job-related costs and business expenses.
While Company A's setup is fairly common, there is a certain logic to the way that Company B goes about its accounting. If workers' comp, cellphones, and truck expenses are all tied to having field employees, then those expenses wouldn't exist if the company didn't have a production crew. So it makes sense to include these labor-related costs above the line because they are directly related to the cost of building out the projects.
If you are trying to track your annual overhead figures in order to incorporate them into a reasonable markup figure, then ask yourself this: Where would I need to place accounts—such as cellphone, truck allowance, tool allowance, health benefits—that fluctuate with my labor force? If hiring or firing a worker significantly affects some associated accounts, it would make sense to isolate these accounts from your overhead in order to increase its year-to-year stability.
If you are concerned about how well your business is doing when compared with similar companies, keep in mind that your gross profit figures may be significantly different, but that doesn't necessarily mean that your company is in trouble. By focusing on your bottom line numbers, you will have a better overall indicator of how your business is performing.
