Understanding and consequently being able to calculate gross profit is important for any business. Knowing where gross profit stands allow you to better grasp how well you’re doing in terms of sales. This number consists of total sales revenue minus the cost of goods sold. Now keep in mind, this number does not include items such as overhead expenses, labor costs, taxes, and interest paid. It is strictly used to understand what the business would have made on the product alone. It is maintained by markups. In this article, we will look further at the concept of gross profit, gross profit margin, and also how a company can calculate both.
Understanding Gross Profit
Arriving at your gross profit again depends upon subtracting the cost of goods sold from gross sales. You will not however deduct operating expenses. To understand the difference, here are some examples:
Cost of Goods Sold (COGS) are those expenses directly tied to the manufacturing, shipment, and delivery of the product to the end-user. Such could include:
- Material used
- Packaging costs
- Shipping fees
- Machinery used
On the other hand, operating expenses tend to be fixed expenses that a company expects to pay every month or year, but that is not necessarily directly responsible for the production and delivery of the items sold. So in this instance, operating expenses may include:
- Payroll taxes
- Interest paid on any loans
- Advertising efforts
The following formula therefore applies: Gross Profit = Sales Revenue – COGS
Calculating Gross Profit
As an example, let’s look at the following…You are a spa owner and have decided that you are going to start selling at-home spa packages. You pay approximately 120.00 for the items contained within the package. To have those items shipped to your facility costs 15.00. Furthermore, your cost for the packaging itself is 30.00. When a customer comes in, they proceed to buy your new at-home deluxe spa package for 250.00. To figure out where your gross profit is, all you do is to simply add up the total costs and subtract from 250.00. So on this product, your gross profit is 85.00.
Why do you need to know this number? After all, you’re not figuring all expenses into it—only those directly tied to the product itself. You need to have this number to calculate the gross margin.
Understanding Gross Margin
A company’s gross margin reveals how good a sale truly is. That is to say, a higher gross profit margin is usually always better and can help a company stay ahead of the competition. In effect, most companies differ, even if they’re within the same industry. They have different locations, a different number of employees getting paid, different advertising strategies. So to truly compare them, gross profit margin proves a valuable metric.
To calculate the margin, you will first need to arrive at that gross profit number. This then will be divided by total revenue. If we were to use an example, let’s say a company has a gross profit of 150k. And their total revenue is 430k. This then leaves you with a margin of approximately 34%. Using this percentage, you can then look at your competitors—what happens if they have a higher margin? This may mean that there is room for you to raise your price somewhat. Or it could also mean that your production/shipment processes are inefficient and thus costing you more than they should.
Improving Your Gross Margin
There are steps you can take and things you can start implementing to try and improve that profit margin if it is not exactly where you need it to be.
- Look at different gross profit margins. In other words, your total profit margin could be deceiving. So review all relevant items/sales divisions and see which items are the better money makers and where consequently, you may be suffering from a lower profit margin.
- Review your pricing. If your profit margin is on the lower side, again, this could indicate a need to raise a particular price. Especially if your supplier’s prices have gone up, then odds are you may need to follow suit to keep a healthy profit margin.
- Try and avoid discounts. Discounts can wipe out an otherwise decent profit margin. It may be tempting, especially during more difficult economic moments, however, this is one of the quickest ways to destroy your margins.
- Increase sales volume. What tends to happen when you sell more of an item is that the cost of goods sold decreases as you can purchase/ship more in bulk. This will inevitably increase your gross margin.
- Reevaluate the cost of goods sold. This is one of the primary things you’re going to need to do to increase your profit margins. Odds are, there are some kinks in the system somewhere. Some parts of the process (or numerous parts) are inefficient and thus way too costly, thereby bringing down your margins. You might shop around suppliers. You could also investigate cheaper materials. Is there more efficient equipment that could be brought in to cut down on manufacturing time? Explore all nooks and crannies when it comes to the COGS. This could most definitely help you bump up that gross profit.
Several key indicators say something about the financial health of a business. Figuring out your gross profit and also profit margin is incredibly important when it comes to evaluating your products, your sales, and your overall processes. This will give you a better handle on how you rate against the competition and what you might need to do to improve moving forward.
First Union Lending works with small businesses, getting them the funding necessary for whatever projects they have in mind. If you’re looking to launch a new product, expand your facility, hire more staff, we can help. Call today for more information!