Everything You Need to Know About Gross Profit Formulas
Depending on your business’s industry, gross profit may be more relevant than net income or other performance measures. Although these figures are all obviously highly related, understanding the differences between them is still very important.
In this post, we’ll explain what you should know about using gross profit formulas. By taking the time to understand everything that goes into this particular metric, you may be able to improve the way your business performs over time.
What is Gross Profit?
Businesses use gross profit to show how strong their revenues are once you’ve accounted for the cost of producing the goods and services associated with them. In other words, business owners have recognized that simply looking at revenues is no longer enough—these revenues will only be worthwhile if they’re significantly greater than the cost of producing them.
Gross profit is also sometimes referred to as sales profit or gross income. It’s important to note that the formula used for calculating gross profit only accounts for some of the expenses associated with running a business (COGS). Other expenses, such as depreciation, amortization, and taxes, won’t be accounted for until later.
How is Gross Profit Calculated?
Despite the fact that the formula for calculating gross profit is quite simple, it’s still one of the most widely quoted figures in the world of business. In order to calculate gross profit, you’ll need to know your revenue and the cost of goods sold (COGS).
- Revenue is a term used to describe all positive cash flows, without accounting for any of the associated expenses.
- Cost of Goods Sold is a term that accounts for the direct cost of producing a product or service. This will usually include all materials and labor expenses involved.
In order to calculate gross profit:
- Gross Profit= Revenue – Cost of Goods Sold
Clearly, the formula is very straightforward. The difficult part of determining your gross profit will be determining the numbers that you use.
What Are Some Common Mistakes Made When Calculating Gross Profit?
Generally speaking, there are two common ways that people incorrectly calculate their gross profit: misstating revenue and misstating cost of goods sold.
Though, the terms “revenue”, “profit”, and “income” are sometimes (wrongly) used interchangeably in casual conversations, these terms actually mean very different things. Revenue is a term that describes all of the money that your business has received. Income and profit are both terms used to describe revenue once it has been adjusted. When compared to the other options, revenue will always be the highest figure.
COGS can be even more confusing. While labor and materials will certainly need to be accounted for, things such as distribution and marketing costs won’t be ignored. The general formula used for COGS is:
- COGS= (Beginning Inventory Costs + Additional Inventory Costs) – Ending Inventory
In order to avoid misstating your gross profit, it’ll be very important to be careful when calculating each of these inputs.
How Does Gross Profit Affect Business Operations?
As is the case with most comparable metrics, gross profit can help describe the general financial health of your business. For example, if your business currently has a negative gross profit, then it’s clear that something needs to change.
When all else is equal, your business will want to have the highest gross profit possible. This means that in order to improve your overall operations, you should strive to either increase revenues or decrease the cost of goods sold (or both). If your gross profit continues to increase over time, this is likely an indicator that your business is moving in a positive direction.
Gross profit is determined by subtracting COGS from revenues. When planning your business strategy for the upcoming year, remember to keep this figure in mind!
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