When it comes to measuring the health of your small business, there are many metrics, and one that sits high on the list is profitability. Understanding gross profit and how to accurately calculate it will provide valuable information on current business performance as well as opportunities for improvement.
First, what is gross profit? Gross profit—sometimes referred to as gross income—is how much revenue your company has produced after you subtract the cost of production.
Gross vs. Net Profit
Conversely, net profit, another commonly used metric, looks at your total income and subtracts all operating expenses, not just the variable ones associated with creating your product. While also a valuable benchmark, net profit casts a much wider net into overall finances than gross profit, which takes a specific view of production costs and their impacts.
Understanding your gross profit provides crucial insights to help set prices for goods and services with customers while informing optimization choices, like evaluating supplier costs and determining staffing needs.
Gross profit also demonstrates your company’s feasibility to be profitable while producing a good or service, and this proof is invaluable when applying for a loan or line of credit.
Additionally, keeping accurate records of gross profit helps companies measure their progress year over year. And finally, companies who understand their gross profit margins can better determine how to increase cash flow and implement margin-based pricing strategies.
How To Find Gross Profit in Six Steps
Now that you understand what gross profit means, are you ready to determine the gross profit of your small business? Follow these steps to learn how:
- Pick a specific timeframe to measure, perhaps a calendar year or fiscal year. This will help ensure that you are looking at data consistently as you evaluate your balance sheets over time.
- Gather your financial statements. In addition to being useful to the exercise of calculating gross profit margin, preserving accurate financial records can help you maintain compliance, communicate with stakeholders, and be better-prepared when interfacing with banks for new accounts or loan eligibility.
- Add up your total sales, or revenue, for your chosen time period. Often referred to as the top line because of its placement on a company’s income statement, the revenue number encompasses the total amount a business receives from customers without subtracting any expenses. In a retail environment, be sure to factor in circumstances such as promotional prices and product returns.
- Determine the cost of goods sold (COGS). COGS are all the expenses that are tied to the cost of producing a product, which can be categorized as direct labor, materials, and overhead. In a service business, COGS include labor, payroll taxes, and benefits of staff working the billable hours. In other business models, such as retail or wholesale, COGS are generally the merchandise sold. It’s important to note that COGS only includes the variable expenses directly related to manufacturing your product; fixed costs, such as salaries, office expenses, and marketing are not included. However, those are still important expenses to track and should be captured elsewhere on the balance sheet.
- Now that you have all your numbers together, you can plug them into this formula to determine your gross profit:
Gross Profit = Revenue – Cost of Goods Sold
Record this number and the inputs you used to reach it into your financial records, and be sure to reference them the next time you calculate gross profit to ensure your process is consistent.
Gross Profit: A Practical Example
To see the formula in action, let’s consider this example, which looks at the gross profit of a coffee stand.
If the coffee costs $0.80 per cup to make and you sell 400 cups daily at $3 per cup, what is your daily gross profit?
Your revenue, or total sales, is $3 x 400, or $1200. Your cost of goods sold, meaning the cost to produce the coffee, is $0.80 x 400, or $320.
Now that you have those core numbers, you can update the formula to calculate gross profit.
Gross Profit ($880) = Revenue ($1,200) – Cost of Goods Sold ($320)
Moving Forward
Once you have determined your gross profit, you may decide that it’s appropriate to make some modifications to your business model. If your profits are not as high as you hoped, one option is to consider raising the price you charge for your products or services. Conversely, now that you have a good understanding of your cost of goods sold, you may want to look for opportunities to reduce costs along the supply chain.
Either way, be sure to think these changes through from all angles, including the impact they may have on your customers and employees, to make sure the adjustment is an appropriate move for your business.
Instead of making one of these changes, you may determine that you’d like to expand your available cash flow. It may be appropriate to consider a traditional loan or bank loan at this point, and there are many options depending on your specific needs.
For newer businesses who may not have the credit history to secure a traditional loan, trade credits can potentially help increase purchasing power and develop new relationships.
Additional Resources for Small Business Owners
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