This guide will tell you everything you need to know with regard to Gross Profit, how to calculate it, and why it matters. If you are not focused on making a profit, then your business is unlikely to be able to do so. Gross Profit and Net Profit are not the same things, and it’s critical to distinguish between them.
Gross Profit (In Short)
In a nutshell, the definition of Gross Profit is that you deduct your Total Revenue from the Cost of Goods Sold (‘COGS’), which is explained in more detail below.
Gross Profit is sometimes referred to as Gross Income, Sales Profit, or Gross Profit Margin (though Gross Profit Margin is typically expressed as a percentage). Because there are so many terms and definitions, it can sometimes get a little confusing.
As per the Generally Accepted Accounting Principles (‘GAAP’), it is a legal requirement that Gross Profit be broken out and clearly labeled on all Profit and Loss statements to avoid deception.
Gross Profit vs Net Profit
Gross Profit is not to be confused with Net Profit. Net Profit is a more intricate definition that takes more variables into account. In addition to subtracting the Cost Of Goods Sold, you will also subtract tax, operating expenses, and interest.
In this manner, Net Profit is a more accurate definition of the real profit of a company. It is entirely possible to have a huge Gross Profit and a tiny (or even negative) Net Profit due to operational inefficiencies. Net Profit is often referred to as ‘Net Income’ – they are the same thing.
Gross Profit vs Gross Margin
Gross Profit and Gross Margin are actually quite similar metrics in many respects. But the Gross Margin is relative to the price it costs to produce a product, while the Gross Profit only refers to the pure profit from the sale. The formula for Gross Margin Percentage is:Gross Profit Formula
|Gross Margin Percentage = (Gross Profit/Sales) x 100|
Gross Margin is a good indication of the overall operational efficiency of a business, and it is a percentage figure. You could have twice the Gross Margin compared to a similar business. But if you pay your employees twice as much or you have additional concerns, your Gross and Net Profit could be identical. So Gross Margin is important, but clearly not as important as Gross and Net Profit.
In business, the bottom line is how much profit you end up with each year. So if you are looking for a good online small business loan or a loan from the bank, the lender will give priority to Gross and Net Profit, and may not even look at Gross Margin in any great detail.
Gross Profit vs Revenue
Revenue is the total amount of income/sales your business is taking in for a given time interval (typically a year). Gross Profit is the proportion of Revenue left over after you have subtracted the Cost of Goods Sold.
So you could say that Gross Profit is a subset of Revenue. Revenue is commonly referred to as ‘Sales’ and is the total amount that the business is taking in without any deductions.
A business can have huge Revenue but no Net Profit, if it is going on a downward spiral. In order to take in huge amounts of revenue in the first place, the business would likely have to have had huge Net Profits in previous years.
Gross Profit Formula
The formula for Gross Profit is quite straightforward
|Gross Profit = Revenue – Cost of Goods Sold|
However, COGS can change depending on what your method of accounting is and what you actually classify underneath the label of ‘COGS’. This will affect how your Gross profit is represented. On the other hand, revenue is revenue, and will always stay the same.
The GAAP principles do not mention COGS, so small business owners do have a level of discretion at their disposal. The IRS website even lists some examples of personal service businesses that do not calculate COGS on their income statements. These include doctors, lawyers, carpenters, and painters.
Gross Profit Example
Let’s take a straightforward example. Many businesses will only list one or two items under COGS on their income statements in order to keep things as simple as possible. Service companies will list it underneath the ‘Cost of Services’.
A small manufacturing business might have labor costs of $13,000 and material costs of $8,000. If it’s total revenue for the year is $33,000, then the gross profit will be $12,000. Of course, there will be many more additional expenses on top of this, and its Net Profit could be far smaller.
The Net Profit is what the business owner will actually take home. Many businesses will include shipping and packaging costs into their COGS, and this is a matter of accounting preference. But if you run a small home-based business that ships small items direct to consumers, it makes more sense to include shipping and packaging in these costs.
Gross Profit Strengths And Limitations
Gross Profit does not tell the full story when it comes to the profitability of a company. The majority of investors will look first and foremost at Net Profit, which is the most accurate metric. Next, they might look towards Gross Profit, as a means of increasing Net Profit.
Gross Profit is really a meaningless metric when taken by itself. It is to be viewed as part of a broader picture of metrics to get a better idea of the overall viability of a business.
The strength of Gross Profit is that it is an indication of managerial soundness, as well as future scalability. If your Gross Profit is large right now, then it could raise exponentially when the business expands into other markets.
Understanding COGS – Essential for The Gross Profit Formula
It is vital to comprehend COGS in order to run a successful business and to calculate Gross Profit comfortably. The most relevant item to understand about COGS is that it is only the direct cost of producing the goods and services. The cost of marketing and sales are not taken into account in terms of COGS.
Another point to take into account is that COGS can vary a little depending on what accounting method is used. There are 3 methodologies of calculating COGS – First in First Out (‘FIFO’), Last in First Out (‘LIFO’), or the Average Cost Method. Note that COGS is only relevant to the sale of physical items. Service companies like legal firms, software firms, or real estate agents do not list COGS. Instead, they have a ‘ Cost of Services’.
COGS is recorded as a business expense on financial statements. The lower the COGS, the higher the profitability. COGS will typically include:
- Management of labor.
To give you the example of a car manufacturer. COGS would include the physical labor done by people on the floor, including the inspection of the cars to meet quality assurance standards. The cost of the materials used to create the vehicle would also be included. The cost of selling the car to customers (and the salaries of the salespeople), as well as the cost of shipping to dealerships, would not be included.
Many people confuse COGS with fixed costs. Many fixed expenses (though not all) are contained within COGS. But they are not purely the same thing. It can also get a little tricky. For instance, the salary of managers/supervisors might be included under COGS, but it can also be regarded as a fixed cost, as it stays the same.
So when people say that variable costs are never under COGS, it is not true 100% of the time. The best way forward is to keep COGS as simple as possible and only include labor and materials. Other expenses can be classified elsewhere in the financial statements. As long as you are consistent in your approach, it is fine. The way that you record COGS can have positive or negative tax implications, so talk to your accountant for the best method to use.
4 Best Ways To Increase Gross Profit
There are many mechanisms to increase Gross Profit. Increasing Gross Profit is often synonymous with increasing Operational Efficiency, which translates to reducing the cost of production while increasing the speed of production. The following are 4 of the most direct ways to increase your Gross Profit.
#1 – Increase the Price
The most obvious way to increase Gross Profit would be to increase the total price you are selling it at. But you need to be a little bit careful about doing this. Customers, especially in the modern era, do not take kindly to sharp price increases. A small increase every year is much more appropriate. But, what they hate, even more, is if you subtract features from them. Never do that. It will be seen as taking something from them that was theirs already.
#2 – Utilize Smart Pricing
There are many psychological principles underlying the sale of goods and services. In one experiment, sales of the Economist Magazine increased by 43% merely by adding a third meaningless ‘Decoy’ subscription option.
This is known as the Decoy effect. Ever wonder why all online subscriptions present you with 4 options, and it always makes sense to upgrade to the latest model? The way you represent your products for purchase is one of the most cost-effective ways to increase both your Gross and Net Profit, for free.
#3 – Utilize Discounts and Trials
Ever wonder why businesses are crazy to offer you a 30-day free trial? Like smart pricing, this is well-grounded in psychological theory. When people invest attention in your brand, they will be reluctant to leave you.
Do everything you can to get people into your ecosystem. Even if you do not offer services or information business, you should get suppliers and contractors into your network as much as possible. Coupons, discounts, trials, and other options are great for expanding your business.
#4 – Decrease Operational Expenses
This should actually be done after you have exhausted. People really do not take kindly to pay cuts. And you might get away with using inferior materials for a while, but your customers will eventually spot the difference. If you are building a brand or reputation, using cheaper quality materials is not the way to go about it.
However, you can still look into ways of intelligently decreasing your expenses. You can streamline operations for maximum efficiency. Just take a look at McDonald’s and Starbucks. The hiring, serving, and marketing processes are uniform across the globe, for employees, customers, and managers.
Increasing Gross Profit in a Service-Based Business
A service-based business is one that does not rely on the sale or manufacture of physical goods. So the term ‘Gross Profit’ can take on a different meaning in this context. Still, there are many ways that you can increase Gross Profit in a service-based business. The primary methods will include:
- Negotiating with subcontractors for better rates.
- Increasing operational efficiency.
- Cutting production costs.
- Making use of automation.
The most relevant point here is to make heavy use of automation tools to enhance business efficiency. Service-based businesses are largely driven by digitalization. Whether you are involved in real estate, healthcare, or education, the software platform you use to manage documents and produce results will play a huge role in your output.
There are many disparate project management tools that can really help to increase the production levels of your workforce. In many instances, you can even get automation tools to do all of the work, which can cut down on the number of wages you need to pay for both fixed workers and contractors.
Another option to increase operational efficiency for a service-based business is to make increased use of contractors. These can be hired on a short-term basis and you don’t have to worry about the insurance and other benefits. Short-term contractors and automation tools are arguably the most direct ways to cut costs and increase Gross Profit for service-based businesses.
Gross Profit is really the most straightforward of all the financial calculations. It is merely the Total Revenue minus the Cost of Goods Sold. The only real issue is that COGS is not strictly defined as per the GAAP methodology of accounting.
In other words, you will need to do more research into your industry and perhaps talk to your accountant about the best way to proceed. Gross Profit is mainly a sign of managerial efficiency but is not as relevant as Net Profit for investors.