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 to your business’s future.
In this blog post, we’ll explain what you should know about calculating and utilizing gross profit formulas. Once you understand this metric, you can improve the way your business performs over time.
What is Gross Profit?
Most likely, you use gross profit to show how strong your business’s revenues are. Typically, this is calculated once you’ve accounted for the cost of producing the goods and services that come with them.
In other words, business owners have recognized that simply looking at revenues is no longer enough because these revenues will only be worthwhile if they’re much 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 to calculate gross profit only accounts for some business expenses.
For short, calculate gross profit is often referred to as COGS. Other business expenses, such as depreciation, amortization, and taxes, won’t be accounted for until later.
How is Gross Profit Calculated?
The formula for calculating gross profit is quite simple. However, it’s still one of the most widely quoted figures in business. In order to calculate gross profit, you’ll need to know your total 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 related 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?
There are two common ways that people incorrectly calculate their gross profit: misstating revenue and misstating cost of goods sold.
Although the terms “revenue,” “profit,” and “income” are sometimes (wrongly) used interchangeably, these terms actually mean very different things.
Revenue is a term that describes the total amount of money that your business has earned. Income and profit are both terms used to describe revenue once it has been adjusted. When compared to the other options, gross revenue will always be the highest figure.
Calculating your business's COGS can be even more confusing. While labor and raw materials must 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, you must be careful when calculating each of these inputs.
How Can Gross Profit Affect Your 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 profit possible. This means that to improve your overall operations, you’ll need to increase revenues or decrease the fixed cost of goods sold. Or, you may need to do both in order to fix your business's financial situation.
If your gross profit increases over a measured period of time, this is likely an indicator that your business is moving in a positive direction.
Conclusion: Regularly Monitor Your Business’s Financial Metrics
To review, gross profit is calculated by subtracting COGS from revenues. When planning your business strategy going forward, remember to keep this figure in mind! By reviewing your gross margins, you can get an accurate view of your total sales, operating expenses, and other factors.
Editor’s Note: This post was updated for accuracy and comprehensiveness in January 2021.