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.
- Gross Profit= Revenue – Cost of Goods Sold
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