If you are here to learn about what gross profit is and why it is on the income statement, you have come to the right place! Here is a look at what it is, how it calculates, what it can tell you about a business and why it is so important. You will learn all about What Is The Gross Profit Formula? Here Is The Simple Answer to make you understand in easiest way.
In this guide, I will walk you through the answers to all those questions.
Gross profit requires income statement entry that reflects total revenue minus cost of goods sold (COGS). it’s a company’s profit before operating expenses, interest payments and taxes. It is also known as gross margin. Gross profit can thus, be defined as the profit a business makes after covering the expenses required to make a sale. Simply put, gross profit is a business’ total sales, less the cost of goods sold.
In other words, the gross profit of a business is simply revenue from sales minus the costs to achieve those sales. Or, some say sales minus the cost of goods sold. It tells you how much money a company would have made if it didn’t pay any other expenses such as salary, income taxes, copy paper, electricity, water, rent and so forth for its employees.
Gross profit (as opposed to net profit) will not include items like interest paid on loans or debts, taxes, depreciation or amortization. It also will not typically include one-time charges or credits.
Gross profit is important because it shows the core profitability of a company before overhead costs and it illustrates the financial success of a product or service.
Gross profit uses to calculate gross profit margin which is calculated by simply dividing gross profit by total revenue (gross profit / total revenue). Calculating gross profit margin let you compare similar companies to each other and to the industry as a whole to determine relative profitability. Companies with higher gross profit margins have a competitive edge over rivals, whether because they can charge a higher price for goods/services (as reflected in higher revenues) or because they pay less for direct costs (as reflected in lower costs of goods sold).
The gross profit figure is a great deal because it is used to calculate something called gross margin, which we will discuss separately. In fact, you cannot really look at a gross profit on its own and know if it is “good” or “bad.”
When you look at an income statement, instead of searching for a needle in a haystack, GAAP rules require gross profit to broke out and clearly label as its own line, so you can’t miss it.
The information that lies between sales and net profit on your profit and loss statement can give you tremendous insight into how your business is performing. But what do these numbers mean? How are they calculated? Why do you need to know them?
Gross profit is the profit a business makes after covering the expenses required to make their products or provide their services. The goal should always be to maximize this metric without sacrificing quality.
The gross profit formula is:
Gross Profit = Total Sales – Cost of Goods Sold
Profit, both achieving it and understanding it, should be easy, but one look at your profit and loss statement (P&L) can leave you swimming in a sea of confusion. And if you don’t know how to find a gross profit, you will, understandably, be even more lost.
Many business owners dive straight to the bottom of their P&L, where net profit, or the bottom line, lies. With this treasure already in hand, it is tempting to ignore operating and gross profit. For this reason, a lot of small business owners have a good understanding of the surface (sales) and the sandy bottom (net profit) of their P&L, but they miss a whole ocean of great information in between.
The equation for determining gross profit is pretty straightforward:
Gross Profit = Total Sales – Cost of Goods Sold
In order to fully understand gross profit, you have to understand the difference between variable and fixed expenses.
The cost of goods sold is the price of all inventory sold which includes both fixed and variable costs. Fixed costs do not change based on production. Examples of fixed costs are:
Salaries of employees
Payroll taxes and employee benefits
On the other hand, variable expenses are costs that can change based on how much you’re producing. Examples of variable costs are:
Credit card fees
Sales staff commissions
Both fixed costs and variable costs can have a large impact on gross profit. The more you can keep your fixed costs down and lower your variable costs, the greater gross profit you can expect.
Let us assume you own a stand on the beach and you sell snorkel sets. The only cost associated directly with making a sale is the amount you paid to purchase the snorkel sets are you selling to folks who come to the beach unprepared.
If you price your snorkel sets at $20 each and you sell 10 sets before you hit the waves at noon, you will have made $200 in sales. The calculation for this is mentioning below:
$20 per snorkel set x 10 snorkel sets sold = $200 in sales
But, you have to pay for the snorkel sets you sold. Chances are you paid in full before your supplier shipped them to you, but you need to replenish your stock, otherwise, you will not have anything to sell and your beach stand will go out of business. Let us assume that you purchased your snorkel sets for $5 each. The cost of the 10 snorkel sets you sold then, is $50.
$5 cost per snorkel set x 10 snorkel sets purchased for resale = $50 in cost of goods
This means your gross profit is $150:
$200 in snorkel set sales – $50 paid to snorkel set supplier = $150 gross profit
This $150, in turn, gets used to maintain your beach stand, advertise at the tiki hut down the shore, etc.
Gross profit, then, is the money you have available to run your business after paying for the goods or services that let you make the sales in the first place.
As is often the case, quite a bit of data can get buried in “cost of goods sold.” This can include merchandise purchased for resale (like your snorkel sets), raw materials, labor costs, and sometimes merchant account fees.
Accountants and bookkeepers can debate for days about what expenses actually belong in cost of goods sold. Help them out by making sure your accountant or bookkeeper has a good understanding of your business operations. You want them to set up your chart of accounts with the appropriate costs posted to cost of goods sold.
Now that you have found your gross profit, what do you do with it? As is the case with all profit, you want to try to maximize it. Since gross profit is the difference between total sales and the cost of what you are selling, increasing gross profit directly impacts your bottom line.
Any business that sells a product can increase gross profit by doing a number of things. First, lowering the cost of goods can maximize your profits. Many suppliers will offer a discount when making large purchases in bulk. Others will offer a seasonal discount if you have room to store products until you need them.
Say, you found a new supplier who will sell you snorkel sets for $4.50 instead of $5. Those same 10 snorkel sets now cost you $45, making your gross profit $155. That is $5 dollars more you can use to enhance your beach stand, hire an employee so you can catch the waves sooner, or put straight in your business bank account.
Anything you can do to increase efficiency or decrease cost directly improves your gross profit, meaning you can make more money without having to increase sales. This is critical in a competitive market where other businesses are selling the same product or service as you. There are really only two ways to increase your top line in a sustainable manner: You must either raise the price of your products, or you must increase your sales volume.
In a competitive market, neither of the above options may be available to you. This makes maximizing your gross profit even more important. You might not be able to change your top line much, but maximizing your gross profit might give you a distinct advantage over your competition.
If you run a service-based business rather than a retail business, increasing your gross profit also means you can earn a larger profit doing the same amount of work. You can do this by using automation, streamlining systems, or negotiating pricing with sub-contractors who can help you provide your service. Sub-contractors often give better rates if you pay for a large block of time upfront and some will even offer a discount if you sign up for an automatic payment plan.
The more you can increase efficiency in your service-based business, the greater the gross profit you can expect. Increasing the cost of service, as long as it does not alienate your customer base, will also help your bottom line and increase your gross profit.
The gross profit formula uses to calculate your gross profit margin. The gross profit margin is a good way to measure your business’ production efficiency over time. While gross profit is a dollar amount, the gross profit margin is a percentage.
The gross profit margin formula is:
Gross Profit Margin = Gross Profit (Revenue – Cost of Goods Sold) / Revenue
Because gross profit can rise while gross profit margins can fall, it can be misleading to simply calculate just gross profit without considering the gross profit margin.
Just as those new to diving often start by learning to snorkel just off the shore, those new to exploring their financial statements often gain confidence by learning one metric at a time. You now know how to find gross profit and why finding it is important. Once you are comfortable with the gross profit formula and learn to maximize it in your business take some time to get familiar with operating profit and net profit.
All three types of profit will tell you something new about your business, and you will be an expert profit and loss diver in no time!