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Profit—both achieving it and understanding it—should be easy, but one look at your profit and loss statement can leave you swimming in a sea of profit confusion.
Many business owners understandably dive straight to the bottom of their P&L, where net profit, or the bottom line, lies. With this treasure already in hand, it’s tempting to ignore operating and gross profit on your way back to the surface.
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 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?
Let’s start with a little below-the-surface exploration. Grab a pair of goggles and a snorkel, and get ready to learn how to find gross profit.
Gross profit lies just below the surface of your profit and loss statement, in the shallow end, so to speak.
Gross profit is 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.
Seems easy enough, right?
The equation for determining gross profit is pretty straightforward:
Sales – Cost of Goods Sold = Gross Profit
Let’s pretend 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 (you have a captive market … take advantage of it!) and you sell 10 sets before you hit the waves at noon, you will have made $200 in sales.
$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 won’t have anything to sell and your beach stand will go out of business. Let’s pretend 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’ve 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.
Let’s say you find 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’s $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 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 your prices, or you must increase your sales volume.
In a competitive market, neither of these options may be available to you. This makes maximizing your gross profit even more important. You may 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.
To increase gross profit in your service-based business, look for ways to maximize efficiency.
You can do this by using automation, streamlining systems, or negotiating pricing with subcontractors who help you provide your service. Subcontractors often give better rates if you pay for a large block of time upfront, and some will offer a discount if you sign up for an automatic payment plan.
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 this metric 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’ll be an expert P&L diver in no time!