The gross profit metric shows a business’s profit based on its revenue and cost of goods sold. By knowing the exact figure of your business’s gross profit, you will gain a deep insight into your operational efficiency and financial performance, allowing you to take immediate action to improve.
This article will give you a simple explanation of what gross profit means and a quick guide on how to calculate it correctly.
What is Gross Profit?
A business’s gross profit is the difference between its sales revenue and the cost of goods sold (COGS). Gross profit reflects how much the company actually earns from selling its products and/or services.
Gross profit appears on the company’s income statement and it can also be referred to as gross income or sales profit.
How to Calculate Gross Profit
To calculate gross profit, subtract the cost of goods sold (COGS) from the total amount brought in from sales.
The formula for Gross Profit
Gross profit = Revenue – COGS
Now, let’s take a closer look into the two factors that make up gross profit:
- Revenue: the money generated from the total sales of your products or services. Revenue represents your gross income before deducting any expenses and taxes. Note, some companies may substitute net sales for total revenue when computing gross profit. Essentially, net sales are the same as total revenue, except it deducts the price of refunded or returned sales, allowances, and discounts, if any.
- Cost of Goods Sold (COGS): includes all of the direct costs and expenses involved in producing, selling, or delivering your goods and services. Here are some typical examples of COGS:
- Raw materials
- Direct labor costs in production
- Shipping fees
- Utilities in production
- Product packaging fees
COGS excludes indirect costs and fixed costs, such as rent, office expenses, salaries for administration staff, depreciation, advertising, etc.
Example of How to Calculate Gross Profit
Below is the income statement of ABC Inc:
|Cost of sales||95,000|
|Administrative and other expenses||10,000|
|Financial services operating and other expenses||8,000|
To calculate the company’s gross profit, we first have to determine the cost of goods sold, which is $95,000 in this example. Remember, do not include administrative, operating, or other expenses as they are not directly involved in making the products. Next, we calculate how much our total revenue is, which comes to $130,000 in the example.
Based on those figures, we subtract the cost of goods sold from revenue to work out the gross profit: $130,000 – $95,000 = $ 35,000.
- Gross vs. Net Income: How Are They Different?
- Balance Sheet Explained – A Basic Guide.
- Why Cash on Hand is Important to Your Business?
How Can the Gross Profit Metric Help Your Business?
Gross profit is one of many basic accounting and financial tools available for small businesses. It focuses on one simple fact: the higher your revenue and the lower your production costs are, the greater your gross profit is. By knowing the exact number of your business’s gross profit, you will have a sound idea of whether the production process could or should be more cost-efficient.
You can then look for effective solutions and take immediate measures to maximize your gross income. For example, if you notice that manufacturing costs are too close to or exceed your revenue, try different cost-effective methods to lower COGS by switching to a cheaper supplier or reducing your packaging weights. Alternatively, you can also try to boost sales by stepping up your marketing campaigns.
The Limitations of Gross Profit
The gross profit metric’s major flaw is that it doesn’t account for all of a company’s expenses and income sources, so it’s not really useful when it comes to analyzing real profitability.
Another point is that the gross profit metric is a fixed number unique to your company – you can’t use it to compare with your competitors. For example, it wouldn’t make sense or bring any useful insights if you compared the gross profit figures of a newly established startup with an established company in the industry.
Instead, to compare, you should compute the gross profit margin – a financial ratio that shows how well a company makes income relative to how well it manages its manufacturing costs. You can then use this ratio to compare against other companies as gross margin percentages are all depressed in proportion to the magnitude of each company’s sales and COGS.
Formula for gross profit margin (GPM):
GPM = Gross Profit/Revenue
Gross profit is a useful and easy-to-calculate metric that allows businesses to understand their financial performance on a deeper level, resulting in greater profits. However, to see the broader picture of your business’s efficiency, it’s best to analyze and use the gross profit metric with other financial ratios as well.
Want to Learn More About Business?
If you’re interested in entrepreneurship, startup stories and want sound business tips, get more posts like this by subscribing to the Shoeboxed blog.
Shoeboxed is an application that lets you digitize all your paper receipts in just a few seconds. It automatically extracts and categorizes important data from your receipts which then gets human verification. Quick, reliable, and trustworthy, Shoeboxed promises to organize your piles of documents in the best way possible!
Check out some of our latest articles:
- Best Ways to Store Your Receipts and Keep Them Organized.
- Financial Services Marketing: Definition, Benefits and Best Practices for Small Businesses.
- What Is A Tax Write-Off? 5 Most Common Write-Offs For Small Businesses.