To begin with, let us understand what the term 'gross profit' means.
Gross profit is the money your company makes after selling a product or service. To calculate the gross profits of your business, you need to subtract the cost of goods sold (or COGS) from the revenue (or sales) that you have made. This is also known as the sales profit.
Gross profit evaluates a company’s capability at using its labor and material supplies in the production of goods or services.
This is the formula to calculate your business' gross profit -
Gross Profit = Revenue – Cost of Goods Sold (COGS)
The COGS includes the direct costs involved in your product or service. They are mainly the production cost, material cost, sales charges, and shipping charges.
COGS takes the variable costs into account and not any fixed costs.
To understand this better, consider yourself as the owner of a startup for a clothing business. The COGS for your venture will include the following -
- The purchase cost of the clothing material that is sold
- Utilities purchased to make the finished product
- Sales staff commission
- Payment of staff
- Shipping charges for the selling process
On the contrary, the COGS will not include -
- Rent for office space
- Wages of non-sales staff
- Bank loans
- Insurance charges
- Other office equipment
Now that you have understood what your business' gross profit is, let's understand the concept of net profit.
Unlike gross profit, net profit takes all the fixed operating charges into account. It is the revenue minus the production cost, taxes, and loan interests. In other words, it signifies the organization's financial status after every expenditure has been paid off from the total revenue generated.
The formula for net profit is -
Net profit = Total Revenue – Total Expenditure
To understand its relationship with the gross income, consider the following formula -
Net profit = Gross Profit – Operating charges – Taxes – Loan payment
Although net income gives a more precise and inclusive number to measure your business, gross profits and net profits are vital parameters to consider.
Theories will be of no help unless you study an example of gross profit calculation.
Consider yourself the owner of a bag manufacturing company.
You make leather bags and sell them for $75 each. The making charges include the following -
- $20 for leather per bag
- $15 for weaving utensils per bag
- $5 for shipping per bag
- $10 for sales incentive per bag
- $10 for labor per bag
- $300 for rent of office space
- $100 as bank loan interest
- $50 as taxes
- $1000 as payroll
You sold 50 bags in January 2021. What is your gross profit?
Step 1: Calculate the revenue.
Revenue = 50 numbers x $75 per number = $3750.
Step 2: Calculate the COGS.
COGS = 50 numbers x (variable cost per number)
= 50 x ($20+$15+$5+$10+$10) (from bullet points 1, 2, 3, 4, & 5.)
= 50 x $60
Step 3: Apply gross profit formula.
Gross profit = Revenue – COGS
= $3750 - $3000
Therefore, the gross profit of your bag manufacturing business is $750.
Gross profit is essential because it signifies the effectiveness of management in utilizing material supplies and labor in the manufacturing process.
It helps evaluate your company's profitability and financial growth.
If you figure out that your revenue and gross profits are not directly proportional to each other, you can imply that the fixed costs are holding you back. For example, if your revenue has gone up by 15% and your gross profit has gone up by only 8%, it means you need to examine your direct costs.
Your business' gross profit provides a guideline to keep your direct costs on track and allow you to carry out your business according to plan.
It is evident that just learning the gross profit component of your company won’t help comprehensively analyze your business' financial health. A significant drawback is that it does not take the fixed costs into account.
Let us extend the example stated above.
From selling 50 bags in January 2021, your business grew to sell 120 bags in April 2021. You had two employees back then, and now you hired four more. You rented bigger office space, and your taxes have increased marginally. The gross profit data may show an upward surge, but calculating your profitability statement shows you a downward slump in your net profit.
Another drawback is your calculation method.
Consider you bought raw materials in bulk in January 2021 for three months. Your gross profit will be low in January as compared to the subsequent months as a result.
A higher gross profit in the current year than the last year will not necessarily mean good financial health, and vice versa.
Let's now understand the gross profit margin formula.
Gross profit margin ratio = Gross Profit / Total Revenue
Gross profit percentage formula = (Gross Profit / Total Revenue) x 100%
Consider a scenario where your company is ‘X.’
Revenue for company X is $500,000, COGS for company X is $200,000.
Gross profit = $500,000 - $250,000 = $250,000.
Gross profit margin ratio = $250,000 / $500,000 = 0.5
Gross profit percentage = ($250,000 / $500,000) x 100% = 50% or 50%.
Consider another scenario where your competitor company is ‘Y.’
Revenue for company Y is $900,000, COGS for company X is $600,000.
Gross profit = $900,000 - $600,000 = $300,000.
Gross profit margin ratio = $300,000 / $900,000 = 0.33
Gross Profit percentage = ($300,000 / $900,000) x 100% = 33% or 33%.
If you compare your company to your competitors, you see that despite their high revenue and gross profit, your performance is better than theirs.
Isn’t this fascinating?
You now know that a profit margin ratio or percentage is a more accurate parameter to assess your business' performance.
It is essential to understand how often you should calculate your gross profit. As an owner, you must decide this frequency depending on the changes taking place in your organization. An increase in th number of clients, increase in production quantity, and changes in prices are a few factors that can induce this calculation.
It can be done quarterly in some cases, while a yearly check will suffice for some businesses.
Consider yourself a table manufacturing company. A new client has generated a hike of 25% in your revenue, but your gross profits have only increased by 12%. It implies that either your material or sale charges or shipping expenditures have increased. In such cases, you need to reevaluate your selling price or cut down your COGS to enhance profit.
Consider using software available in the market to give you accurate and periodic data.
Although the calculations and examples might seem easy to do and understand, the challenging part is maintaining accurate data. To ensure that all the required data is included in the calculation, you might need specialized bookkeeping services to minimize errors and generate an accurate report.
You can categorize an expense as fixed or variable and then include it in your COGS to calculate your gross profit. An ideal bookkeeping service like Fincent can take care of all your gross profit calculations for you and generate accurate reports at all times.
In manual calculation, errors in data entry could lead to inaccurate results, thereby causing delays or hassles. An accurate report will always keep you guided on the correct path, thus ensuring that your business is on the path to success.
It is not mandatory to be a gem in management studies to excel in your business. It is not essential to have sturdy investment support to run a business efficiently. A few simple tricks of the trade, certain vital calculation practices, and knowledge of current market trends can help you sail through any situation.
This article emphasizes the importance of gross profit and lists the methods to calculate it. Periodic checks on gross profit, genuine data consideration, and the right vision can help you succeed.
As a professional bookkeeping agency, Fincent can cater to a wide range of creative businesses like designers, developers, event management companies, freelancers, artists, independent consultants, musicians, and more, to ensure that their accounts are always accurate and up-to-date.