If you manage your business finances on an ongoing basis, the central concept you need to establish is profitability. Understanding gross profit and calculating it on a continuing schedule is a cornerstone to building and growing your organization.
This discussion defines gross profit, cost of goods sold, how to calculate gross profit and gross margin and why this is important to the future of your business.
What Is Gross Profit?
Gross Profit or GP is the revenue from sales minus the costs to achieve those sales. The cost associated with sales is known as “Cost of Goods Sold” or “COGS” and is often in its own section on your income statement.
GP tells you exactly how much your company would have made if you didn’t have administrative or other expenses that weren’t directly associated with the product or service you provide.
To better understand gross profit, we must also look at our expenses.
Expenses or costs are divided into two categories: fixed and variable cost. Fixed costs are counted as operating expenses and remain consistent month to month. They are often grouped into a section called “Sales, General & Administrative” or “SG&A.”
Variable costs (COGS) cover all other expenses.
Fixed cost examples (SG&A):
- Rent
- Office Phones
- Salaries
- Employee Benefits
- Insurance
- Payroll Taxes
Variable cost examples (COGS):
- Utilities Not Fixed
- Hourly Labor
- Packing and Shipping
- Equipment
- Depreciation
Cost of Goods Sold
Cost of goods sold or COGS on an income statement represents all of the expenses a business pays to manufacture, source, and deliver a product to the customer. This amount is subtracted from the organization’s revenue to determine gross profit.
COGS are everything from raw materials to freight charges. Costs like marketing expenses and overhead are not included. However, cost of goods sold does include paying the labor force that makes and assembles the final product.
Cost of goods sold is crucial because this is the true cost of doing business. If COGS increases, gross profit will decrease. Knowing these costs help managers and investors understand the company’s bottom line.
Calculating GP
The gross profit calculation is one of five equations used to measure a company’s profitability.
GP is calculated by subtracting the cost of goods sold from the revenue.
For example, let’s say you manufacture coffee beans. You would first total the COGS, including buying the raw Cacao beans, utility costs for roasting the beans and labor costs for assembling the beans for packaging, and finally, the cost of shipping the beans to the customer.
If the total sales revenue for selling the beans for the month is $800,000 and the cost of goods sold totals $600,000, then you made a $200,000 net profit for that month.
The final equation would look like this:
Gross Margin
Gross margin is the gross profit expressed as a percentage of revenue and is calculated by dividing the gross profit by the sales or revenue and then multiplying by 100.
Let’s use our coffee bean manufacturing example again. We would complete the formula by inputting the gross profit and dividing it by the revenue, multiplying it into a percentage.
Therefore, every dollar of coffee bean sales generates about 25% gross margin.
There are two ways to improve your gross margin. A business can increase its product price or lower the variable costs associated with producing these products.
Long-Term Effects
Utilizing gross profit will encourage managing an organization’s labor and supplies in the production process. It will help you identify critical sectors to reduce costs and increase revenue in the planning process.
“We look at gross profit margins on a weekly basis to be adaptable and pivot at speed while providing proactive leadership and fact-based decision making,” says Claude Compton, founder of Pave Projects. “This regularity allows the business to ride-out changing tides and isolate any issues before they become a long-term problem.”
In addition to making changes, monitoring your business’s profit margins on each line of business will give you useful data to identify the most profitable areas within your organization and scale them.
Make use of accounting software that automatically generates your firm’s gross profit with FINSYNC’s all-in-one accounting platform.