Achieving and understanding profit 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 calculate 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’s tempting to ignore operating and gross profit. For this reason, a lot of small business owners have a good understanding of the sales and the net profit of their P&L, but they miss all of the information in between.
In this guide, therefore, we’ll walk you through what lies between the sales and net profit, including how to calculate gross profit and why it matters to your business accounting. Let’s get started.
Gross profit is the revenue a business brings in after covering the expenses required to make a sale. Simply put, gross profit is a business’s total sales, less the cost of goods sold.
Seems easy enough, right? It can be. But, how do you calculate gross profit exactly? That’s where the gross profit formula comes in.
The equation for calculating gross profit is simple:
Sales – Cost of Goods Sold = Gross Profit
To fully understand gross profit, however, you have to understand the difference between variable and fixed expenses.
Fixed costs don’t change based on production. Examples of fixed costs include:
On the other hand, variable expenses are costs that can change based on how much you’re producing. Examples of variable costs include:
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.
The cost of goods sold is the price of all inventory sold which includes both fixed and variable costs.
As is often the case, however, quite a bit of data can get buried in the “cost of goods sold.”
This can include merchandise purchased for resale, raw materials, labor costs, and sometimes merchant account fees.
Business accountants and bookkeepers can debate for days about what expenses actually belong in the cost of goods sold. You can 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 the cost of goods sold.
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 you are 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.
$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.
The gross profit formula can also be used to calculate your gross profit margin. The gross profit margin is a good way to measure your business’s production efficiency over time. Whereas 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.
Now that you’ve found out how to calculate 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.
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 more you can use to enhance your beach stand, hire an employee so you can catch the waves sooner, or put straight into your business bank account.
Anything you can do to increase efficiency or decrease costs directly improves your gross profit, meaning you can make more money without having to increase sales.
Increasing gross profit 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 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.
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 doesn’t alienate your customer base, will also help your bottom line and increase your gross profit.
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 calculate 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, you can take some time to get familiar with operating revenue and net profit.
All three calculations will tell you something new about your business, and you’ll be an expert at reading your profit and loss statement in no time.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.
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