Gross profit is a metric used by business owners to determine the profitability and financial performance of their businesses. It's an important part of business accounting that's typically calculated at the end of each fiscal year. Skynova offers all-in-one accounting and invoicing software to help small businesses keep track of their expenses and generate financial reports.
Being able to increase your gross profit without sacrificing the quality of your products or services is key to improving your bottom line. Explore our guide below to learn more about what gross profit is, why it's important, how to calculate it, and how Skynova's business software can help you improve your accounting practices today.
What Is Gross Profit?
Gross profit is an accounting measurement that shows the amount of profit remaining after deducting certain expenses from a business's revenue. To calculate gross profit, you first need to determine your total sales and the total amount of expenses incurred as a direct result of a product's production. Known as the cost of goods sold (COGS), these various expenses could include:
- Raw materials used
- Direct labor costs, hourly or otherwise dependent on output levels
- Sales staff commissions
- Credit card fees on purchases by customers
- Equipment depreciation
- Production site utilities
- Shipping or freight
Gross profit isn't easy to understand, but it's important to learn so you can identify profitability trends and take action when needed. For example, if you compare your business's gross profit to previous years and find that the amount has fallen, it may be time to make some changes. Business owners also use a gross profit to determine their growth profit margin, which we'll discuss further in this guide.
Calculating Gross Profit
Calculating gross profit is a simple formula used to find how much revenue for a product remains after the cost of production. Follow this formula to calculate gross profit:
| Revenue |
| − Cost of Goods Sold |
| = Gross Profit |
If you're unsure how to calculate gross profit, Skynova's accounting software can help, and so can the following four steps.
Step 1: Understand the Difference Between Variable Costs and Fixed Costs
Before you can use the gross profit formula, you'll need to decide on an accounting method and inventory cost method to keep track of all financial transactions. You'll use these records to gather some preliminary information before working on the formula. Also, you'll only use your variable costs in this equation, thus excluding your fixed costs.
Understanding Variable Costs
Variable costs are expenses that change based on production levels and other circumstances. These costs are usually more fluid and refer to expenses such as materials used, product packaging, and freight charges. The more product you make, the higher your variable expenses are going to be.
Sometimes you have control over these variables and other times you don't. For example, a utility company increases its rates, which affects the cost of utilities for your plant or warehouse, or shipping costs increase one year compared to the past.
It's not all bad though, as variable costs can also decrease. For instance, you could get a discount on materials from a supplier, which allows you to create the same product for less.
Understanding Fixed Costs
Fixed costs are more stable and predictable. These costs are associated with operating expenses instead of production costs. Fixed costs include:
- Office expenses, such as the supplies needed to operate
- Rent or mortgage payments
- Salaries and wages of employees
- Payroll taxes
- Employee benefits
- Advertising
- Expenses associated with promotions and sales
- Insurance
- Professional fees
When trying to differentiate between fixed and variable costs, remember that if it's not directly related to a product's production then it's likely a fixed cost.
Step 2: Calculate Revenue
Revenue is the total amount of money your business made from sales. To calculate revenue, you'll need to keep track of all sales of either goods or services, depending on what your company offers to its customers. The formula for calculating revenue is:
| Price |
| × Quantity |
| = Revenue |
When using accounting software, the total revenue of your business is typically found at the top of your income statement.
An income statement is a report that shows your business's revenue, expenses, and profits from both operating and nonoperating activity. It's also known as a profit and loss statement or an earning statement. An income statement is used to see how profitable your business was over a specific period.
Step 3: Calculate the Cost of Goods Sold
The cost of goods sold (COGS) is the total amount it cost to produce the goods you sold. It can be found on your income statement. The cost of sales is the same thing as the cost of goods sold. They're the direct costs of producing a good. The formula to calculate the COGS is:
| Beginning Inventory |
| + Purchases |
| − Ending Inventory |
| = Cost of Goods Sold |
Unsold goods from the previous year are known as beginning inventory. Add any purchases or production costs from the current year to the beginning inventory amount. From this total, subtract the ending inventory, which means the products that weren't sold by the end of the year. The resulting number is the cost of goods sold and the final step before determining your gross profit.
Step 4: Determine Your Gross Profit
Now that you've calculated your revenue and the cost of goods sold, you can determine your gross profit. Remember to use this simple formula:
| Revenue |
| − Cost of Goods Sold |
| = Gross Profit |
Although the formula is very easy, it can be difficult to determine your total revenue and expenses. Skynova's business templates and accounting software can help you manage your financial transactions throughout the year. We've designed our products to help make accounting and understanding your profitability much easier. When you utilize all that Skynova has to offer, your business's financial records will be in one place online.
How to Calculate Gross Profit Margin
Gross profit margin is the same metric as gross profit, but it's calculated as a percentage instead. This measurement tells you the percentage of revenue remaining after production costs have been deducted. The gross profit margin formula used to calculate this metric is:
| Gross Profit Margin | |||
|---|---|---|---|
| = |
|
||
| And then multiply by 100 to get a percentage instead of a fraction. |
|||
Simply put, you divide your gross profit by your revenue and multiply that number by 100 to find the percentage of your gross profit margin. It's a good way to measure your business's efficiency over time, as you can compare it to other years' margins. The higher your gross profit margin is, the more profitable your business is.
Gross Profit Calculation Examples
Example: Calculating Gross Profit
Let's look at an example of a small business owner who's trying to figure out their gross profit for the year. They want to determine if their T-shirt company's gross profit is higher than the previous year's amount of $150,000. They've earned $500,000 in revenue and spent $300,000 in the cost of goods sold. To calculate their gross profit, they subtract $300,000 from $500,000 to determine that their gross profit for the year is $200,000.
Example: Calculating Gross Profit Margin
The T-shirt company owner now wants to calculate their gross profit margin to better determine their profitability. Last year, their gross profit was $150,000 with a 33% margin. This year, their gross profit is $200,000. To calculate their gross profit margin, they divide $200,000 by their revenue of $500,000. The result is 0.40, which is multiplied by 100 to get a total margin of 40%. This result shows that the company is more profitable now than it was before, or in other words, they were able to keep more in revenue than the previous year.
How to Improve Your Gross Profit Margin
Improving your gross profit margin increases your net profit (i.e., your bottom line). There are a few ways to increase your business's profitability. No matter which type of business you run, it's important to look for ways to increase efficiency and decrease costs. Here are some ideas based on the type of business you own.
Sales-Based Businesses
If you run a sales-based business, your focus is on producing and selling goods. One of the best ways to increase your gross profit is to decrease how much it costs for you to produce the same goods. For example, you can shop around with different suppliers to try to lower your material costs. You may be able to find one that offers a bulk order discount or a seasonal discount.
Another option is to change the pricing of your product to increase your sales revenue. You want to offer a fair price that's competitive with other businesses, but you can try to increase the selling price without going so high that you lose customers. If you feel like the markup on your goods is already at the highest level it can be, it's worth trying to increase your sales volume instead. Think of how you can sell more of the same product.
If you sell multiple products, study each product's gross profit margin. It may be time to cut out some less profitable products from your business plan to place greater focus on those with the highest profit margins. Finally, look for ways to reduce inventory waste (i.e., products lost due to spoilage, theft, or other issues).
Service-Based Businesses
If you run a service-based business, your goal of a higher gross profit margin means that you're trying to earn a larger profit for the same amount of work. First, you can look for ways to increase efficiency. Your services would take less time to perform but would still cost the same as before. This option enables you to provide more services than before and increase your profits over time.
Another course of action is to increase the cost of the service to the customer. This is a riskier move but is possible, especially if you originally priced your services too low. You could also try negotiating rates lower with subcontractors if you hire them to help you provide a service. Decreasing expenses plays a major role in increasing your gross profit.
Finally, if you offer multiple services, consider which ones are more profitable than others. You may want to stop offering the least profitable services. Your business could replace these services with new ones that could offer higher profit margins, or you could focus on the work that provides the highest profits.
Let Skynova Help You Determine Your Gross Profit
Gross profit is an accounting measure used to understand the financial health of your business. The higher your gross profit margin, the more profitable you are. Determining and understanding your gross profit helps you make better decisions about your company's operations and finances.
Skynova's invoicing and accounting software can help you streamline your financial records and get paid faster, improving your cash flow. Our business templates, like our free invoice template, were made to be as intuitive as possible. If you have any questions, our knowledgeable support team is ready to help. Depend on Skynova's software to simplify small business accounting today.