Gross Profit Definition | How to Calculate It With Formulas and Examples
Calculating gross profit margin leaves many people scratching their heads in confusion. If you’ve looked over your P&L (profit and loss) statement, it’s understandable why you might be struggling to formulate a solid number. One of the most common mistakes that business owners make is to skip to the bottom of the P&L for their net profit. While it’s true that this number gives you a general ballpark of profits, it doesn’t take into account operating costs or gross profit. Without these figures factored into the formula, you’re not going to get a definitive analysis. It’s important to know what data needs to be included in your report and how it affects your gross profit. To ensure that your business accounting is accurate and correct, our experts here at Seek Capital have put together this handy resource for calculating gross profit.
Gross Profit Defined
Your business’s gross profit is the amount of money you have made after deducting costs associated with producing and selling your product or service. While the formula is simple enough on paper, there are some important components that need to be factored into the equation.
Calculating Gross Profit
Calculating gross profit is essentially your sales minus the costs that went into making those sales. For example, let’s say your income statement shows that your company made $50,000 in sales, yet your COGS (cost of goods sold) for that period was $10,000. Your gross profit for that period would be $40,000. The remaining $40K will be put back into your business to ensure that it remains successful. A good business owner would take the gross profit to help advertise their brand, improve operations, and anything else that is for the good of the company. Again, the formula is straightforward enough. But to get a grasp on gross profit in its entirety, you need to understand what the difference is between fixed and variable costs . Let’s take a moment to explore what these two mean so have a better understanding of what goes into calculating your business’s gross profit.
Fixed Costs
These are the costs that never change throughout the production of your goods. Some examples of fixed costs are things like the rent and taxes you pay on your building or warehouse, business insurance, and paid salaries, taxes, and benefits to your employees.
Variable Costs
Unlike fixed costs, variable costs can change throughout production. These are expenses like materials used in the manufacturing of your goods, costs associated with shipping your goods, employees paid hourly, fees associated with credit cards, and any commissions earned by your sales staff. As you can see, both fixed and variable costs play a huge role in your gross profit. If you can learn how to keep both of these costs to a minimum, you’re more likely to enjoy a higher gross profit.
Understanding COGS
Your business’s cost of goods sold (COGS) is the total amount of inventory that you have sold, plus your fixed and variable costs. The actual COGS data is often disputed among bookkeepers and accountants . What one person thinks belongs under COGS, another is sure to disagree. It isn’t uncommon for gross profit to be off due to inaccurate sales data or leaving out things that should have been included, such as merchant fees, goods bought to be resold, labor, and other factors. This is why it is so important and helpful to keep an accurate record of where expenses are going and how they relate to your business. The better your accounting team understands your operations, the closer your numbers will be. With this new information in mind, let’s take a more in-depth look at calculating gross profit . Let’s assume that your business sells tires for $100 each. You currently have 200 tires in stock and you sell all of them. That’s $20,000 in revenue. $100 X 200 tires = $20,000 in revenue Next, we have to factor in your costs. Let’s assume that you pay $30 for each tire. $30 X 200 tires = $6,000 in costs Now, we can take your revenue and subtract your costs to get your gross profit on the tires your business sells. $20,000 in revenue - $6,000 in costs = $14,000 in gross profit You now have $14,000 to help find your business for whatever purposes you deem necessary for the good of your company. A well-functioning business will be able to balance this cyclical process to keep its doors open and increase revenue.
Calculating Gross Profit Margin
Now that you have the formula for calculating gross profit, you can use it to figure out your business’s gross profit margin. Basically, gross profit is the monetary amount that your company makes, while the gross profit margin is the percentage of that amount. Factoring gross profit margin is necessary to see how efficient your business is in its operations. To figure out what your gross profit margin is, you will need to divide your gross profit by your total revenue and multiply the outcome by 100. Using the values from above, let’s observe the formula for determining your gross profit margin. $14,000 (gross profit) ÷ $20,000 (revenue) = 0.7 X 100 = 70% gross profit margin
Increasing Your Gross Profit
Knowing how to calculate your gross profit is the first step in learning how to maximize it. Your bottom line is directly impacted when you increase your business’s gross profits, so it’s important to focus on doing all that you can to improve sales. In businesses that sell goods, one tactic to increase gross profits is to lower the cost of producing those goods. Oftentimes, the more material or product you buy, the bigger the discount is that you get on those items. You may also want to inquire about seasonal discounts on the items you buy. Just keep in mind that you will need to have plenty of room to store those items until you are ready to use them. You may also want to keep your ear to the ground for a new supplier that can offer you a better deal on the goods you sell. Using the tires example, maybe you find a new supplier that sells the same brand for $20 instead of $30. If you regularly keep an inventory of 200 tires, you will have effectively saved yourself $2,000 in your cost of goods sold. Your new savings can be put toward improving your business in various ways. Whether it’s on advertising, hiring new employees, or upgrading your building, there are countless things you can do for the good of your company. As long as you use that income with the goal to benefit your brand, you will have made a successful move to maximize your profits. Many successful companies are always on the lookout for ways to increase the efficiency of their operations. If a manufacturer can upgrade their equipment to produce more products per hour, they will have a clear advantage over the competition to meet supply and demand. Bottom line, you should continually look for ways to lower the cost of goods sold . In doing so, your gross profits will soar and continue to improve over time. This isn’t something you’re going to be able to do overnight. But with a commitment to bettering your brand, you will make small steps here and there that ultimately equal out to long strides. While the above examples are general and may not necessarily apply to you, it’s important to look for improvements that do pertain to you. Get creative and maintain an attitude that you’re going to do all that you can to make your brand a success. It takes time, but the more you familiarize yourself with maximizing gross profits, the more likely you will be to improve your business. Successful businesses are constantly researching new ways to lower their out-of-pocket expenses. Whether it is money that goes toward the upkeep and maintenance of operating equipment or finding cheaper components for goods sold, you should never stop trying to figure out how to maximize your gross profits. It’s also important that you never get comfortable with your gross profits. What’s working for you one day could soon be improved by a competitor, leaving your business scrambling to catch up. In the meantime, you could lose out on a considerable amount of sales while the other guys clean up financially. As such, run your business in a way that is always trying to improve every aspect of sales and operation.
Summary
The key is to get comfortable with calculating and using your gross profit data. Once you have mastered the formula and are capable of getting an accurate, factual number every time, you will be able to better evaluate your operations. From there, you can be more strategic with making changes and adjustments throughout your company. With enough practice, you can successfully scale your business and maximize your gross profits. Sources https://www.thestreet.com/how-to/how-to-calculate-cost-of-goods-sold-for-your-business-14590206 https://corporatefinanceinstitute.com/resources/knowledge/accounting/fixed-and-variable-costs/ https://money.usnews.com/careers/best-jobs/accountant