According to the U.S. Bureau of Labor, 80 percent of small businesses survive their first year, and 50 percent even make it to their fifth year. The secret to their longevity? Managing their cash flow.
While there are several ways you can track and manage your cash flow, gross profit is one of the top contenders. You can use it to determine where you should scale up, and where you should cut back.
Keep reading to learn what gross profit is and how to calculate it.
What Is Gross Profit?
Gross profit (also known as gross income) is the amount of money you make from selling your products and services after you deduct the costs of producing them.
For example, if you run a coffee shop, you’ll count the cost of coffee, sugar, milk, and other ingredients under production costs. To calculate your gross profit, subtract that cost from your sales revenue.
You can find gross profit on the company’s income statement. Gross profit is typically used to calculate a company’s gross profit margin, which shows your gross profit as a percentage of total sales. Unlike gross profit, the gross profit margin is a ratio, not an actual amount of money.
Already know enough about gross profit and need to quickly calculate it? Use our handy calculator or keep reading to learn more.
Importance of Gross Profit
Why should you calculate gross profit?
Gross profit is a way to determine how efficient your business is. It shows how effectively you use your resources—direct labor, raw materials, and other supplies—to produce end products. It helps you decide where you can save money and where you should invest it.
For example, if you see gross profit falling without any change in your item’s selling price, it tells you that your production costs have increased.
An increase or decrease in your gross profit is an indicator of your business’s performance. Suppose we look at the financial statements of two businesses with the same amount of revenue but different gross profits. We can infer that the business with the higher gross profit has a competitive advantage over the other—maybe they have a machine that runs faster or they bought raw materials in bulk to get a discount.
How to Calculate Gross Profit
You can calculate your gross profit with the following formula:
Gross Profit = Revenue - Cost of Goods Sold
Revenue
Revenue is the total money your company makes from its products and services before taking any taxes, debt, or other business expenses into account.
For example, if you own a coffee shop, your revenue is the amount of money your customers pay for their coffee.
Cost of Goods Sold (COGS)
The cost of goods sold (COGS), or cost of sales, refers to all direct costs and expenses that go towards selling your product. If you don’t get coffee orders, you don’t use coffee beans or milk.
When you do get orders, material costs (what you pay for coffee beans or milk) and labor costs (what you pay baristas to make coffee)—add up. The same goes for other variable costs such as packaging and other ingredients you need to make your product.
COGS doesn’t include costs such as rent, utilities, payroll taxes, credit card readers, and advertising. You don't include these indirect costs because they aren’t considered the materials or services you need to directly make your product.
Still, some portion of these fixed costs—for example, an increase in electricity due to using your coffee maker more often—is included in your COGS because they were used during the creation of the product.
Gross Profit Formula Example
As an example of gross profit calculations, pretend you’re a coffee shop owner who sells a cup of espresso for $3. If the coffee costs $0.80 per cup to make and you sell 400 cups daily, what’s your daily gross profit?
Using the above gross profit formula, you would make $880 in gross profit daily.
Still, you wouldn’t take home the entire $880 in profit at the end of the day. Parts of it will pay for your administrative costs such as rent, marketing, utilities, and salaries of employees not directly involved in making coffee.
What happens when you include those administrative expenses in your calculation? You end up with your net profit.
How to Calculate Net Profit
The net profit (also called net income or the bottom line) is what you get when you subtract your total costs from your total revenue, represented by the following formula:
Net Profit = Revenue - Total Costs
Your total costs are the sum of your COGS, taxes and overhead expenses—such as salaries, rent, utilities, amortization, depreciation, and marketing.
You can calculate your total costs with the following formula:
Total Costs = Cost of Goods Sold + Taxes + Overhead Expenses
Let’s calculate the net profit for the previous example. Assume that you have daily taxes of $200 and overhead expenses of $300 a day.
How much money will you take home daily?
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Based on this calculation, your daily net profit is $380
How to Calculate Gross Profit Margin and Net Profit Margin
As a business owner, you need to track two important financial ratios: gross profit margin and net profit margin.
While they sound similar, gross profit shouldn’t be confused with gross profit margin. Both are financial metrics that show the profitability of your business. Both also depend on revenue and COGS, but that's where the similarities end: Gross profit is an amount of money, and gross profit margin is a financial ratio.
Gross profit margin shows gross profit as a percentage of total sales.
Here's the gross profit margin formula:
Gross Profit Margin (GPM) = Gross Profit / Revenue
Just like the GPM considers revenue and COGS, the Net Profit Margin relies on revenue and net profit. You can calculate that with the following formula:
Net Profit Margin (NPM) = Net Profit / Revenue
This gross profit margin assesses the profitability of your business’s manufacturing activities. The net profit margin provides a picture of your business’s overall profitability. Together, they give you an idea of your business's financial health, empowering you to track trends and make quick business decisions.
If both margins increase, it could be because of a recent trend you can invest in. For example, suppose your coffee shop introduces lattes to its menu. And half of your flat white drinkers start having lattes the next week. Your GPM will increase because lattes have lower COGS than flat whites—flat whites use more milk.
If the overhead expenses remain the same, both GPM and NPM will increase.
You can make the most of this trend by pushing customers to buy more lattes and slowly phasing out the flat white from the menu.
When both margins decrease, that could mean you need to cut expenses somewhere.
You could also have a highly profitable product (high GPM) but lose money (low NPM). For example, you may have increased your GPM by phasing out the flat white but lost several customers in the process. Due to this, the increase in gross profits may not compare with the net loss you experienced due to that customer drop.
One way to address that low NPM would be to reduce overhead costs and rent a smaller space.
What Are Acceptable Profit Margins?
You know the importance of profit margins. But what should you aim for?
According to a study of over 13,000 businesses, the average gross profit margin in the retail industry is 53 percent, but this percentage may be higher or lower for other industries.
Aim for a figure that’s realistic for you and your industry. The NYU Stern School of Business compiled a list of average profit margins per industry that you can refer to.
How Can You Increase Gross Profit Margins?
You can increase your gross profit margins by being more efficient with your resources. In other words, you should:
- Decrease COGS: You can buy raw materials in bulk to take advantage of volume discounts, or train employees to do several tasks so that you don’t have to hire more. For example, baristas should know how to handle the register so you don’t have to pay for a separate cashier.
- Increase prices: This is the easiest option. But pricing increases often cause sales to decrease. If you're not careful and sales drop too far, you may not be able to generate enough to cover operating expenses.
- Increase productivity: Make little tweaks to improve efficiency in your product lines. You may not be able to quantify the impact of increased productivity to your prices and expenses but it does increase your gross profit margins. For example, arranging the workspace to keep items in a designated area could help baristas make drinks faster, reduce wait times, and serve more customers.
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