Ask a shop owner how much profit he made last month and you will often hear a number worked out by taking the cash in the galla and subtracting what went out. That number mixes up sales, purchases, udhaar, stock changes and personal spending. It tells you very little.
Two figures tell you far more: gross profit and net profit. They answer different questions, and you need both.
The definitions
- Gross profit = Sales - Cost of goods sold. It shows what you earn on the goods themselves, before running costs.
- Net profit = Gross profit - Operating expenses. It shows what is left after rent, salaries, electricity, transport and every other cost of running the business.
Cost of goods sold is the purchase cost of the stock you actually sold in the period, not everything you bought. If you bought Rs 3,000,000 of stock but sold only Rs 2,125,000 worth at cost, the rest is still sitting in your godown as stock, and it is not an expense yet.
Worked example: a wholesale grocery business for one month
| Line | Amount (Rs) |
|---|---|
| Sales (after discounts and returns) | 2,500,000 |
| Cost of goods sold | 2,125,000 |
| Gross profit | 375,000 |
| Rent (shop and godown) | 60,000 |
| Salaries (3 staff) | 105,000 |
| Electricity | 35,000 |
| Transport and fuel | 40,000 |
| Generator and UPS running | 15,000 |
| Mobile and internet | 5,000 |
| Miscellaneous | 10,000 |
| Total operating expenses | 270,000 |
| Net profit | 105,000 |
Gross profit is 2,500,000 - 2,125,000 = Rs 375,000. Expenses add up to 60,000 + 105,000 + 35,000 + 40,000 + 15,000 + 5,000 + 10,000 = Rs 270,000. Net profit is 375,000 - 270,000 = Rs 105,000.
As percentages
Gross margin = 375,000 / 2,500,000 = 15%. Net margin = 105,000 / 2,500,000 = 4.2%. In other words, out of every Rs 100 of sales, Rs 15 is left after paying for the goods, and Rs 4.20 is left after paying for everything.
What each number tells you
| If this is weak | Look at | Typical causes |
|---|---|---|
| Gross profit | Buying and pricing | Buying in small lots, too many discounts, prices not updated after supplier increases, stock loss and damage |
| Net profit, gross profit fine | Running costs | Too much staff for the volume, high rent, fuel waste, generator costs during load-shedding |
| Both | The whole model | Wrong product mix, too much udhaar, dead stock |
Margin vs markup
These two are mixed up all the time, and the mix-up costs money. Suppose you buy an item for Rs 800 and sell it for Rs 1,000. The profit is Rs 200.
- Markup is profit divided by cost: 200 / 800 = 25%.
- Margin is profit divided by selling price: 200 / 1,000 = 20%.
If you want a 20% margin and you add 20% to cost, you get 800 x 1.20 = Rs 960, a profit of Rs 160, which is only a 16.7% margin. To get a 20% margin, divide cost by 0.80: 800 / 0.80 = Rs 1,000.
Things that are not expenses
- Stock purchases. They become an expense only when the goods are sold, through cost of goods sold.
- Owner's personal drawings. Money the owner takes home is a withdrawal of profit, not a business expense. Mixing it in makes the business look less profitable than it is.
- Loan repayments. The principal repaid is not an expense; interest or financing charges usually are. Ask your accountant how to treat them.
- Udhaar not yet collected. A credit sale is a sale when made. Uncollected money affects cash, not profit, unless it is written off.
Small changes, big effect
Because net margins in trading are thin, small changes matter a lot. In the example, raising gross margin by just one percentage point, from 15% to 16%, adds 1% of 2,500,000 = Rs 25,000 of gross profit. Expenses stay the same, so net profit rises from Rs 105,000 to Rs 130,000, an increase of about 24%.
Ways to find that one point:
- Update selling prices the same day a supplier raises theirs.
- Track discounts by salesman and set limits.
- Find dead stock and clear it before it loses more value.
- Count stock regularly so losses are noticed in weeks, not at year-end.
- Compare supplier rates for your top 20 items each quarter.
Profit is not the same as cash
A business can show a healthy net profit and still struggle to pay suppliers. In the example, the business earned Rs 105,000 in the month. But suppose customers' udhaar grew by Rs 150,000 over the same month, because more sales were on credit and collections were slow. The profit is real on paper, yet the galla has less cash than a month ago.
The same happens when you build up stock. Buying Rs 200,000 of extra stock ahead of Ramzan does not reduce profit, because the goods have not been sold, but it takes Rs 200,000 out of your bank account today. This is why you should look at profit and cash separately:
- Profit answers: is the business earning money on what it sells?
- Cash answers: can I pay my bills this week?
- Udhaar and stock levels explain the gap between the two.
If profit is steady but cash keeps falling, the cause is almost always growing udhaar or growing stock. Fix collection and buying, and the cash follows.
Profit by product group
A single gross margin for the whole business hides a lot. A grocery wholesaler might earn 8% on sugar and flour, 15% on packaged foods and 25% on toiletries. If the low-margin staples are growing fastest, overall margin falls even though nothing is wrong with pricing. Look at gross profit by product group each month so you know where your profit actually comes from, and give the shelf space and credit to the goods that earn it.
Here is a quick check. If staples make up Rs 1,500,000 of sales at 8% and other goods Rs 1,000,000 at 25%, gross profit is 120,000 + 250,000 = Rs 370,000, a combined margin of 14.8%. Shift Rs 200,000 of sales from staples to the higher-margin goods and gross profit becomes 104,000 + 300,000 = Rs 404,000, with the same total sales.
Getting these numbers every month
To calculate gross profit you need accurate sales and an accurate cost for each item sold. That depends on how you cost your stock; our guide on FIFO vs average cost explains the options. To calculate net profit you also need every expense recorded, including the small ones paid from the galla.
Your accountant will normally check these figures against a trial balance at year-end. But waiting a year to learn your profit is too late. Taajir records sales, purchases, stock and expenses in one place and produces profit reports from them, which the accounting software page describes in more detail. Whatever tool you use, look at both numbers every month: gross profit to judge your buying and pricing, net profit to judge the business as a whole.