Gross Profit
Calculating Gross Profit: The Basic Formula
Your gross profit is the amount of money your firm has brought in by selling your products or services.
The formula for gross profit is revenue minus the cost of goods sold, or COGS.
"COGS" represents only the direct costs that go into each product or service you sold. In other words, these are costs you would not have if you had not made any sales. Your COGS will depend on your product and your business. It generally includes production materials, sales commissions, shipping, and any other costs that are necessary for each product.
It's important to recognize the difference between gross profit and gross profit margin. Your gross profit will be stated for a particular time period, like the year of 2019.
While your gross profit margin uses all the same variables (sale price for each item and the costs that went into that item), it is stated on a per-item basis. For instance, your gross profit margin might be $500 per item sold.
Gross Profit vs Net Profit
One of the most common mistakes business owners make when they look at their gross profit is confusing it with net profit. As we mentioned above, your gross profit only accounts for the direct expenses that go into each product. Your net profit, on the other hand, also subtracts your fixed operating expenses that you would have regardless of how many items you sell.
In other words, many businesses start by taking their revenues and subtracting production costs to get their gross profit. Then they subtract their operating expenses, interest, and taxes from that number to get their net profit.
When you look at how successful your business is, your net profit will be the more accurate and comprehensive number. However, both gross profit and net profit are important calculations to know. You can learn a lot about your business from these individual numbers and from comparing the two.
Calculating a Sample Company's Gross Profit
When it comes to math, sometimes the best way to learn is by doing it yourself. Let's look at an example of a gross profit calculation.
Company ABC manufactures and sells dining chairs at a price of $800 each. Their expenses include:
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$40 in wood per chair
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$8 in fabric per chair
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$2 per chair for wood stain, screws, and other small materials
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$200 per chair in hourly labor
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$16 to ship each chair
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$15,000 per month for salaried payroll
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$5,000 per month in rent
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$500 per month in utilities
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$1,000 per month in interest
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$1,000 per month in taxes
Let's say that in a particular month, the company sold 200 chairs. To calculate their total revenue, we calculate $800 x 200 chairs = $160,000. Now we add up their variable expenses. For each chair, they need to pay for the wood ($40), fabric ($8), small materials ($2), labor ($200), and shipping ($16). That's a total of $266 per chair. When we multiply it by the 200 chairs they sold, their total COGS is $53,200.
Finally, we subtract their total revenue ($160,000) minus their total COGS ($53,200) to arrive at a gross profit of $106,800. The other expenses we listed, such as the salaried payroll, rent, utilities, interest, and taxes, will factor into the net profit, not the gross profit.
The Purpose of Calculating Your Gross Profit
Your gross profit is a quick and helpful way to gauge how well your business performed for a set period of time. It reveals much more, though, when you track how much it changes over time.
For example, let's say you haven't been bringing in as much money as you had hoped. You look at your gross profit and see that it has been growing consistently. This tells you that your problem is an increase in your fixed expenses.
You can also compare your gross profit to your revenue to see if your direct expenses are staying in line with what you had expected. For instance, let's say your revenue has increased by 10% from last year but your gross profit has only increased by 7%. This tells you to review your direct costs to see why they are increasing.
The Limitations of Gross Profit Calculations
As useful as it is to track and analyze your gross profit, it's far from the only number you need in order to tell you if your business is meeting your goals. The primary limitation is that gross profit doesn't account for changes in fixed expenses.
Chances are that your administrative costs will go up as your business grows. Maybe you only needed one administrative employee when you were selling 20 chairs per month. Now that you're selling 200 per month, though, one person can't handle all the reception tasks, accounting, marketing, and other tasks.
Those expenses may go up as your business grows, but they don't vary on a per-item basis. For that reason, they won't factor into your gross profit. Another issue with gross profit calculations is that they may not factor in the expenses that are intermittent, depending on how you calculate it.
For example, let's say you buy your materials in bulk, and you buy three months of supplies in January. At first glance, your gross profit for January will look far lower than it is for February because you already paid a February expense in January.
You can avoid this by using software that tracks your expenses on a per-item basis. For instance, you input that you paid $4,800 for 16 chairs' worth of fabric. The software can calculate that this comes out to $8 per chair.
When your software calculates your gross profit, it can calculate based on $8 per chair. This is more accurate than assuming the $4,800 in fabric was only for the 200 chairs you sold in January.
How Often Should You Calculate Your Gross Profit?
As with most financial reports, your gross profit is most helpful when you look at how it changes over time. By keeping an eye on those trends, you can identify when your COGS is becoming too high to meet your goals. At the least, you should calculate your gross profit on a yearly basis. To keep a closer watch on your finances, though, you should track it on a monthly basis too.
You can also use your gross profit to watch how certain changes are affecting your business. For instance, you may take on a large new customer who raises your total revenue by 20% per month. However, you see that your gross profits have only increased by 10% per month.
In this case, it tells you that your new client is costing you more than you anticipated. You may need to revise your pricing or find ways to cut your COGS.
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