Wondering how to calculate gross profit and what factors affect this number?
We will be giving you the rundown of gross profit, how to improve it, mistakes to avoid, and more.
What is Gross Profit?
Gross profit or gross income refers to your total or gross revenue from sales minus the cost of goods sold (COGS).
Gross Profit vs. Net Profit vs. Operating Profit
How does gross profit differ from other types of profit?
Operating profit or operating income comes from subtracting your operating expenses from gross profit.
Net profit or net income, on the other hand, is gross revenue after subtracting all expenses, taxes, interest, etc. Net profit is your bottom line.
Gross Profit and COGS
COGS represents all costs directly associated with the production and sale of goods and services. The higher your COGS, the lower your profit margins.
Core Profitability
Gross profit reflects a company’s core profitability by measuring how efficiently it manages costs related to the production process.
Gross Profit Formula
Revenue – COGS = Gross Profit
Before figuring out how to calculate gross profit, you’ll need to know two things based on the equation:
- How much total revenue you made in a period
- The direct costs (COGS) associated with that
Explanation of revenue
You generate revenue or sales income through selling products or services. This is from your core business activities and is separate from non-operating revenue.
A simple revenue calculation involves multiplying the number of units, subscriptions, etc. sold by their selling price.
Explanation of cost of goods sold (COGS)
COGS refers to direct costs such as raw materials, labor, and production/manufacturing expenses.
In simpler terms, this is whatever you directly spend to produce or create all your product inventory.
In a service business, they typically use the terms cost of revenue or cost of sales (COS). Because they have no physical product, some of the expense calculations are a little different.
Example Calculation
If a shoe maker earned $9,000 in total revenue for product sales, and your production costs equal $3,000, how much would you have in gross profit?
$9,000 (Revenue) – $3,000 (COGS) = $6,000 Gross Profit
Step-by-Step Guide to Calculating Gross Profit
Let’s go through the process a little more in depth.
Step 1: Identify total revenue (or sales) for a specific period.
In order to identify revenue, you must choose your reporting period: monthly, quarterly, or annually.
Then you must identify how much you sold during that period and multiply that by the price of the unit.
If you sell multiple products, calculate revenue individually and add them together.
Here’s the formula:
Revenue = Quantity Sold x Product Price
Step 2: Calculate the cost of goods sold (COGS) for that period.
Next, for the same period, calculate your COGS.
You must identify the costs associated with acquiring materials and producing or manufacturing the product itself. This normally includes labor and overheads related to the manufacturing process.
The formula for COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory
In simple terms, beginning inventory represents what you had left over from the previous period. Purchases are any acquisition or production costs. Ending inventory is what is left over at the end of the period. This also becomes the beginning inventory for the next period.
Step 3: Apply the formula to determine gross profit.
Now that you know how to find and calculate revenue and COGS, you’ll know how to calculate gross profit.
Example
Say a small retail store is calculating gross profit for a month’s worth of sales.
You’ve done the individual calculations for the units sold per unique product sold and their respective prices. The total revenue for that month comes out to $15,000.
The value of their beginning inventory is $3,000 + $6,000 (purchasing and shipping new inventory) – $1,000 (ending inventory). Their COGS is $8,000.
Therefore, the small retail store’s gross profit for this month is $15,000 (Revenue) – $8,000 (COGS) = $7,000
Using Accounting Software
Accounting software like QuickBooks, Freshbooks, and Wave help you automate these calculations. They can auto-generate reports from your transactions. This includes your income statement, which shows your revenues, expenses, and profits.
Factors That Can Affect Gross Profit
Changes in sales volume
The amount of product you sell within a period directly impacts gross profit. The more product you sell, the more revenue you earn; the more revenue you earn, the more gross profit left over after COGS deductions. It’s true for the opposite. The less you sell, the less profit you make.
Variations in production or material costs
The higher your production and acquisition costs, the lower your gross (and net) profits.
Materials and fuel prices, among other direct costs can fluctuate, which can drive up your production costs.
Inventory management impact
Did you know that poor inventory management can drive up your costs? For instance, overstocking can lead to higher storage costs and greater chances of inventory shrinkage (loss and damage). Even poor negotiation with suppliers can lead to missing out on cost-saving opportunities related to materials and inventory.
Seasonality
Seasonality basically refers to seeing higher or lower demand during specific times of the year. This directly affects sales volume and leads to higher or lower profits for small businesses.
How to Improve Gross Profit
1. Increase revenue while keeping COGS low
One strategy for increasing revenue while keeping COGS low involves methods for optimizing inventory management to reduce storage costs and prevent overstocking.
This includes stocking up only as much as you need. Using data and analytics can also help predict how much inventory you’ll need throughout the year.
2. Negotiate better prices
Negotiating better prices with suppliers can be a delicate process. However, this can lead to greater cost-saving potential.
Some tactics include:
- Finding suppliers who support credit transactions and negotiating flexible payment terms
- Researching and requesting suppliers to give bulk discounts
3. Improve production efficiency
Some ways one can improve production efficiency:
- Implement lean manufacturing principles to help reduce waste in the production process and increase productivity.
- Invest in technology and automation for repetitive processes
- Outsourcing production
- Regularly review your production process
4. Apply pricing strategies
Pricing strategy helps you meet your revenue goals while accounting for demand, seasonality, and variable expenses.
You can leverage pricing strategies such as dynamic and cost-plus pricing. This helps you stay profitable as you account for market conditions, fluctuating costs, and competition.
Common Mistakes When Calculating Gross Profit
Misclassifying expenses
Classifying what expenses count as COGS can sometimes be tricky to determine, especially for businesses just starting out. Just think about COGS as the effort and money that goes into the creation of a product itself. This includes shipping materials to production factories and storage facilities, the overheads of those facilities, and the labor.
Incomplete revenue calculations
When calculating revenue, you have to make sure you’re accounting for things like discounts, returns and allowances. You could overstate your income, which carries a whole load of consequences.
Missing direct costs
Incomplete COGS calculations will have you wondering where all your money went. It’s easy to remember factory rent or raw material prices. However, freight and shipping costs and fuel or electricity needed to run factory machinery are also direct costs. Make sure you account for everything.
Excluding inventory shrinkage
Failure to account for lost, damaged, or expired inventory can lead to discrepancies in your books. This can also lead to delays in delivering these products to customers.
Why Gross Profit is Important for Business Decision-Making
Evaluating product profitability
Gross profit as a key indicator for evaluating product profitability. A higher gross profit margin on a product means its performing well. Simply, the more money you can make on a product after costs, the better.
Setting pricing
Gross profit can reveal if you need to raise prices to keep up with costs. For instance, if you’re breaking even on the gross profit level, that means you don’t have enough to pay for other expenses. This means you need to implement better pricing strategies.
Budgeting and forecasting
Knowing your gross profit margins are important in financial analysis. It helps you identify trends which reveal how effective your current financial management practices are.
This then helps you better create and plan your revenue and expenses for the current and future years.
Cutting costs and reinvesting
Gross profit helps businesses understand if they need to reevaluate their expenses at the manufacturing level.
The more you can save through cost-cutting measures, the more you have to reinvest back into your business.
Also, review and analyze your profit and loss statement because it provides valuable insights into your spending gaps.
Frequently Asked Questions
Can a business have high revenue but low gross profit?
While it is normal for gross profit to be lower than revenue, a drastically low gross profit number could be an issue.
This likely indicates that they have very high production or acquisition costs (COGS) and should consider cost-saving strategies.
What is the difference between gross profit and operating profit?
Gross profit is what’s left over after subtracting COGS. Operating profit is gross profit after you subtract all operating expenses but taxes.
How does inventory management impact my gross profit calculation?
Better management reduces shrinkage and costs related to over or under-stocking. It also reduces the need for markdowns and other strategies to move slow inventory.
Your inventory valuation method also impacts your gross profit margin.
What’s the best way to track gross profit over time?
Use accounting software with inventory management and data tools and insights into your gross profit over the years.
You can also use spreadsheets and business intelligence tools like Tableau.
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We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
In Summary
Knowing how to calculate gross profit is the first step. Now, take what you’ve learned from this and use it to improve your processes, cut down on costs, and improve your profitability.
