How To Calculate Gross Profit

Business owners looking to uncover important information about profitability must become familiar with many figures, including gross profit. This article will help you understand gross profit, how to calculate gross profit and gross profit margins, and why these numbers are critical to more effective business growth and expense management.

What Is Gross Profit?

Gross profit or gross income is defined as all revenues or sales a business receives, less the cost of making and distributing products. This figure considers the variable costs of making a product but excludes selling and administrative expenses. If the company is a service business without inventory, the gross profit and the gross receipts are the same amount.

Gross profit may also be used when describing total revenues. A gross income amount is reported on a company's profit-and-loss statement and is typically a standardized calculation for businesses in the same industry.

What Does Gross Profit Tell You?

Knowing your gross income is valuable for making business decisions. Gross income numbers indicate the health of the business's revenue streams. Business revenue reported as gross income can be broken down by product to determine success.

You may also want to use the individual components of gross income calculations to determine what level of production will allow you to break even and how much business you'll need to generate each month or year to earn a profit. If the cost of producing a product is too high compared to the price customers are willing to pay, the company may not earn enough to cover future expansion.

What Affects Gross Profit?

Given that gross profit is used to measure business production efficiency, many factors come into play. First, consider fixed costs such as rent, employee salaries, insurance, and payroll taxes, among others, all of which must be paid regardless of production. Then, account for variable expenses that can fluctuate depending on business output:

• Sales changes
• Cost of raw materials
• Direct labor costs
• Product shipping costs
• Utilities tied to production
• Inventory identification method (i.e., first in, first out or last in, first out)

The more you can keep your fixed costs down and lower your variable expenses, the more you can expect in gross profits.

Gross Profit Formula

You need two numbers for the gross profit equation: cost of goods sold (COGS) and revenue. COGS represents the direct costs involved in producing goods or buying products for resale, including the purchase price of items, freight, storage, packaging, and direct labor costs. When a company sells services instead of actual products, the cost of services sold can replace COGS. Revenue, or net sales, is the total amount generated from sales in a given period.

The gross profit formula is calculated by subtracting COGS from revenue, and the total is displayed as a dollar amount:

Cost of Goods Sold - Revenue = Gross Profit

How To Calculate Gross Profit: Examples

What is an example of gross profit? Using the formula above, the following examples help illustrate how to calculate gross profits:

• Example 1: A smoothie shop makes $200,000 in sales this year. The business spent $100,000 in expenses (ingredients to make the drinks, cups and lids, staff wages, and processing fees on purchases). Gross profit is calculated by subtracting revenue from expenses, which would be:
  • $200,000 - $100,000 = $100,000 gross profit
• Example 2: This year, a professional services company generated $500,000 from project revenue. The company spent $200,000 to deliver services to their customers. Gross profit is calculated by subtracting yearly revenue from the cost of services sold, which would be:
  • $500,000 - $200,000 = $300,000 gross profit

Remember that these numbers are calculated before the company accounts for operating expenses related to sales, marketing, accounting, HR, administration, legal, income taxes, building leases, and other related costs.

What Is Gross Profit Margin?

Gross profit margin, also known as the gross profit ratio, is a metric used to determine what percentage of the company's revenue is profit. A higher gross profit margin will indicate a greater ability for a company to control costs. This may also play a critical role when the company is looking for business financing or investors, all of whom will want to see its financials and ability to turn a profit while keeping costs in check.

What Does Gross Profit Margin Tell You?

A company's gross profit margin can be used to assess the business's financial health and pricing strategy since it represents the money it makes after accounting for the cost of doing business. If the cost of making a product is too high compared to the price customers are willing to pay, the company may not earn enough.

What Is a Good Gross Profit Margin?

Your gross profit margin will show whether a product makes the business money. A high gross profit ratio indicates that a product generates profit above its labor and other operating costs. On the other hand, a low gross profit margin will show that your sale price is not much higher than the cost required to produce the product. This could indicate that your pricing strategy is off, costs aren't well-controlled, or raw materials and labor aren't used efficiently.

A "good" gross profit margin is relative. Margins will vary significantly by industry, company size, and market conditions. For example, a car dealership in the automotive industry will have a much lower gross profit margin than a bank in the financial services industry. This also illustrates that service industries that don't sell physical products generally have higher gross profit margins because they have a much lower COGS than those that produce actual products.

How To Calculate Gross Profit Margin

Gross profit margin is calculated by dividing gross profit by net sales, then multiplying by 100 to express the metric as a percentage:

Gross Profit / Net Sales x 100 = Gross Profit Margin

The percentage from the gross profit margin formula will indicate profit made before deducting costs such as administrative expenses, depreciation, amortization, and overhead.

How To Improve Your Gross Profit

Once you know how to calculate gross profit and gross profit margin, you can start identifying areas where the business can optimize or pivot. Here are a few options to consider as you look to increase gross profit:

• Reduce operating costs: Knowing how to improve your gross profits requires looking at everything you use to run the business. Start with an audit and identify areas where you may be able to cut back on business functions such as payroll that you could outsource to make the process more efficient.
• Consider your inventory management system: If you have products sitting on a shelf for months or are unclear whether a particular product is in stock, this can drain profits. Ensure you have a system to track products from production to sale. It can also help you track returns, reduce waste, and mitigate shrinkage due to employee or customer theft. You'll also be able to pinpoint sales patterns, such as times of the year when your products are in high demand and stock runs low.
• Revisit your pricing strategy: You may need to reduce prices or run sales and promotions occasionally. On the flip side, raising the cost of an existing product could boost revenue and help your bottom line.
• Do competitive research: One of the many ways to use gross profit margin is to compare your production efficiency with competitors with similar business models. If your business and a top competitor sell the same product for the same price, but they make it for half the cost, they will have an edge in higher gross profits.
• Tap into repeat customers: Retaining existing customers is more cost-efficient than acquiring new ones — a selling tactic that can directly contribute to improved profit margins.

Get Help Keeping Your Finances Straight

When reviewing your company's gross profit, cash flow management will also inevitably come into play. Understanding the profitability metrics used in your industry, such as profit margins, return on assets, or return on investment, can help you understand how the business is earning money and whether you're spending efficiently.

Not sure where to begin? Learn more about how Paychex can help you grow and scale your business finances with our small business solutions.