Gross profit is one of the most important financial figures you need to know about your business. It helps give you a better understanding of your finances, helps you plan for the future, and, crucially, helps increase your net profit (your overall profit). In this post, we’ll look at how to calculate gross profit. First, though, let’s look at why gross profit is important and the differences between gross and net profit.
Why is Gross Profit Important?
Gross profit shows your sales cover the costs incurred making those sales. It doesn’t mean you will make an ultimate profit as net profit takes into account other expenses, but gross profit should always be the starting point calculation.
You must address serious issues in your business if the gross profit and gross profit margin are not healthy. If they are healthy, on the other hand, you can take decisions that will move your business forward.
In addition, understanding your gross profit will help you focus on parts of your business that can be improved. For example, the prices you charge might be too low or you might not be getting a good enough deal from one of your suppliers.
Understanding gross profit and what can affect it can also help you avoid risks. This is because some costs that impact gross profit are both variable and largely out of your control. Usually, this applies to the cost of raw materials.
If the cost of an essential raw material increases dramatically, for example, the impact on gross profit (and, therefore, net profit) can be significant. This is why smart investors like Warren Buffet watch prices of raw materials like sugar when analysing investments in companies like Coca-Cola.
Difference Between Gross Profit and Net Profit
The main difference is that gross profit takes into account the cost of goods sold while net profit takes into account all costs in your business, i.e. the cost of goods sold plus operational and administrative costs.
How to Calculate Gross Profit
To calculate gross profit, you take the total revenue your business generates and subtract the costs incurred in achieving that revenue. This gives you the formula:
- Net Sales – Cost of Goods Sold = Gross Profit
Net sales are total sales (or gross sales) minus product returns, refunds, and sales discounts.
The cost of goods sold includes everything that is directly associated with making the sale. This means it does not include operational expenses and overheads such as rent, insurance, payroll, tax, and more.
What then, does cost of goods sold include?
Cost of Goods Sold
The cost of goods sold depends on the products or services you offer. If you are a service business, the cost of goods sold may not be very much. A consultancy business, for example, may not require materials so only labour costs directly associated with delivering the service count. A cleaning service is similar, although it will have to take into account cleaning products it uses to deliver the cleaning service.
A retailer will have a different and, in many respects, a much simpler calculation to make to determine the cost of goods sold. The figure will normally just entail the cost of purchasing from its suppliers the products it sells. Rent of the shop, staff salaries, advertising, stock control systems, and other expenses are all operational expenses so don’t count as costs of goods sold.
Manufacturing businesses often have the most complex cost of sale equations. Manufacturers need to take into account materials to produce the product, the direct labour involved in its production, packaging, and freight. Utilities for the manufacturing facility usually also count towards the cost of goods sold as well as machinery costs
Whatever type of business you are in, being able to calculate net sales, the cost of goods sold, and, ultimately, gross profit, is essential.
For more help and advice with your business, please contact a member of the Gilroy Gannon team today.