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Calculate Gross Profit (formulas and definitions)

As a small business owner, you have a responsibility to keep guiding your business towards profitability. That’s not always an easy thing to do especially if your business is still in its infancy. The question is, “how do you know if you are running a profitable business or at least have your business headed in the right direction?” The term “information is king” comes to mind. You need the right information to tell you how your business is doing at all times. Yes, getting the information you need involves a lot more than looking to see how much cash is in your company’s bank account. That’s not always an accurate sign of profitability. The best information you can find is the information your accountant or accounting department can provide for you. Even a small set of financial statements can tell you an important story about your business. The problem is you need to understand that upon which you should be relying. To that end, we would like to focus the following discussion on one very important financial concept, how to calculate gross profit.

What is Gross Profit?

Business owners who are unfamiliar with accounting practices and interpreting financial statements will tend to focus on one number, net profit. If there is a net profit, it’s no doubt an important number. However, it’s not always the best indication of how a business is really doing. The best indication of how a business is doing comes from the company’s gross profit numbers. Let’s start this discussion with a definition gross profit as stated by the Investopedia website: “Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Gross profit will appear on a company’s income statement and can be calculated by subtracting the cost of goods sold (COGS) from revenue (sales). These figures can be found on a company’s income statement.” In laymen terms, gross profit is the difference between what a company earns from the sales of its goods or services minus the costs incurred to produce or provide those goods or services. In formula format: Sales – Cost of Goods Sold = Gross Profit Example: If Company A sells 50 widgets at $10 a widget, the company’s gross revenue from sales would be $500. If it cost a total of $5 to produce or acquire each of those widgets, the total cost of the 50 widgets would be $250. Using the gross profit formula, this is how to calculate gross profit: $500 (gross revenue from sales) – $250 (Cost of Goods Sold) = $250 (Gross Profit)

Understanding Cost of Goods Sold

At this point, you might be wondering what items would typically be counted as your cost of goods sold. There are two components to this number: variable costs and fixed costs. Your variable cost is the direct cost your company incurs per unit produced or acquired. This would include direct labor cost, manufacturing materials (if applicable), and shipping costs. The fixed cost is the cost of your company incurs regardless of how many units your company produces, acquires, or sells. The long list of fixed costs includes (but is not limited to), office/factory rent, insurance, payroll taxes, commissions, benefits, and property taxes. It might also include an allocation of expenses like utilities and office supplies. What it does not include is company business income taxes, depreciation expense, and amortization.

How to Calculate Gross Profit Margin

Once you know how to calculate your gross profit, you’ll have a reasonable idea of just how well your company is doing in dollars and cents. A word of caution: this is just a number. If you want to compare the success of your business with other companies in your sector, you would want to also calculate your company’s gross profit margin. The gross profit margin formula will give you a percentage. That percentage is something you can use as the basis for comparison. This is the best way to make industry comparisons when all applicable businesses come in different sizes and shapes. Here is the gross profit margin formula: Sales RevenueCost of Goods Sold / Sales Revenue = gross profit margin Using the example from above, the formula would read as follows: $500 (Sales Revenue) – $250 (Cost of Goods Sold) / $500 (Sales Revenue) = .5 or 50% (gross profit margin). You need to understand there is a difference between gross profit margin and the net profit margin. The gross profit margin represents the percentage of how your company is performing based on its sales. The net income profit margin represents how your company is performing based on all business activities. You would expect your company’s gross profit margin to be higher than your company’s net profit margin unless your company has another meaningful source of income.

How to Use Gross Profit Margin to Make Business Decision

The accounting information you receive from your accountants is worth very little if you don’t use it to help drive your business’ activities. Everything we give to our clients has meaning. If our clients don’t understand the meaning, we are happy to help educate them. As indicated above, you can use your gross profit margin as a means of determining how your company is performing in comparison to other companies in your sector. If your industry’s standard gross profit margin is 40% and your company is running at 50% as stated above, your company is doing very well. It has a healthy profit margin. There might be enough room for your company to offer discounts, perhaps driving your sales even higher. Conversely, you need to know if your gross profit margin is running below industry standards. If the industry sits at a profit margin of say 60% and your company is running at 50% as stated above, there could be issues you might want to address. To drive your gross profit margins higher snd closer to industry standards, you can choose one of three paths. First, you might start by raising your prices a little bit. This might work as long as your prices are below the competition in the first place. If your company’s prices are already inline with the rest of the industry, you would want to look at your expenses. You would likely need to lower your company’s expenses to drive your gross profit margin higher. You can usually achieve this objective by lowering your company’s overhead expenses or renegotiating contracts with your vendors/supplies. In some cases, you might want to consider using both of the aforementioned options. If you increase your sales prices while remaining competitive, you can then target cost savings to drive your company’s gross profit margin closer to where you want it to be. We hope we have served you well with this little tutorial on how to find gross profit and how you can use this key number to manage your business. It’s our hope this newfound understanding will motivate you to learn more about interpreting the financial information that comes from your accountant or account department. If we can be of more service, we hope you will contact us at your earliest convenience.

FAQ

What does a low gross profit percentage mean?

It means that the company’s profit is not enough to keep costing the product or service that it sells in order to keep growing. Nevertheless, that depends on the type of company it is, there can be difficult times for big companies that can suffer a low gross profit margin percentage having to fix prices and become more efficient in producing and selling the products to increase the operating profit. In contrast, the small companies do not usually have a higher profit margin at the beginning, needing to improve the company’s marketing, generating more customers, and having better management of the cash flow. This will improve the gross profit ratio. Otherwise, these small businesses can go bankrupt by not achieving a higher operating profit margin

What is a 50% profit margin

A 50% profit margin is a margin that generates over the income needed to cover the cost of their sale product with a profit of 50% of the sale. Having a 50% profit margin is positive but will always depend on the company and the industry. Having a 50% profit margin is positive but will always depend on the company and the industry. In the market, there are obstacles that can affect the profit margin and it is possible to lose customers. Therefore, It is necessary to adjust the selling price by giving offers and discounts in order to sell. These offers can affect the profit margin if it does not sell a lot, but in case it sells a lot thanks to these offers it will not be negative even if it does not have exactly 50% of the profit. To finish, another point to consider is the average gross profit margin of the industry where a company is located, if the gross profit margin of a company is below the gross profit margin of the industry then it is not positive, the gross margin always needs to be higher or equal.  

Why do you need to calculate your gross profit?

The first step is to have all the business information at hand, no matter if a business is just starting or has been going on for decades, we must always know all the data and information that the company handles. This includes the total revenue, total sales, production cost, direct cost, labor cost, direct expenses, and many more that are necessary for the profit margin calculation. And here is why you need it because when calculating a good profit margin we know how the business is doing if it is in good condition or not to follow and improve in every aspect.

How to calculate a profit margin in excel?

There are many ways to calculate the profit margin, many websites offer free services to calculate the profit margin. However, in case the internet is not present, Excel is the most recommended option to calculate the profit margin. Excel is widely used by accounters as it has ready-made templates that help them to calculate statements. In the case of calculating the net margin in Excel, you have to get the total variable costs and the total variable income on hand, then open an Excel sheet, create a table with the columns income, costs, gross profit or gross margin. Then, after having structured the table, you have to place the figures with their respective cells, subtract the cost of goods manufactured from the revenue and enter the respective formula with the operating expense.

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