Make or Break: Understanding Gross Profit

Get to know your profit better.

how to calculate gross profit

 “What is my gross profit?” A question posed regularly, it seems simple yet confounds even the most involved business owners. The formula is simple and straightforward yet we often find that our clients grossly overestimate (or sometimes underestimate) their gross profit. Why is this and why does it matter? Well, the answer to that is not always as simple as a formula.

What is Gross Profit?

Often referred to as gross margin, gross profit is a derived figure from a basic formula subtracting the cost to produce or deliver goods or services from the total revenue received from it.

To determine your company’s gross profit, you simply take the total revenue and subtract the total cost of goods or services required to produce the goods or services that drove that revenue. Sounds simple, right?

First, note that cost of goods and services does not include general and administrative (G&A) expenses such as utilities, rent, travel & entertainment and salaries for departments not tasked with creating a product or delivering a service. These costs are just a few of the expenses your business may have that do not get factored in to the gross profit formula. These costs may be static and have no fluctuation regardless of service delivery or they could be elective and their inclusion or exclusion may have no bearing on the ability to produce and deliver goods. Whichever category the expense falls under, it simply has no direct relationship to the cost of producing and delivering the goods or service.

Gross profit calculations do include a multitude of fixed and variable costs, from direct labor to materials  that factor directly into the cost to produce goods and services. The problem that many businesses have is simply categorizing expenses correctly.

What Gross Profit Reveals

Although gross profit may seem relatively limited based on the previous definition, it actually gives firms explicit insight into how their products and services are providing value at cost.

Instead of relying solely on earnings before interest,taxes, depreciation and amortization (EBITDA), which also accounts for static operating expenses, companies can more accurately identify their costs of goods sold. This, in turn, enables them to fine tune their business models in a more precise fashion and address cost control and pricing with a more accurate picture.

By working with figures that pinpoint specific cost associations and fluctuations, companies gain the ability to implement modifications with surgical precision. For instance, a firm that uses its gross profit as a guideline can target specific issues, such as increased material costs from a supplier, instead of simply cutting back on everything just to reduce operating expenses related to a sole product line or service offering.

Additionally, monitoring your gross profit as a key performance indicator (KPI) is an excellent way to keep tabs on any underlying shifts in productivity, material costs and market rates. As a general rule, monitoring gross profit on a regular basis will alert you to changes and allow you to pivot to keep profitability at required operating levels.

Gross Profit Margin

Calculating a gross profit margin is one of the most common uses for gross profit figures.

This margin is a percentage value garnered by simply dividing your gross profits by your sales. The figure that results instantly paints a crystal-clear picture that depicts the profitability of your back-end model as well as your sales strategies—assuming of course that the underlying numbers are accurate.

While many reporting statistics already suggest whether or not you need to increase cash flows, gross profit margins go a step further. This figure explicitly tells you how much you'll need to heighten sale prices or reduce material expenditures to hit a given target.

When tracked historically in combination with P&L statements and balance sheets, gross profit margins can also make it easier to identify workable strategies that result in increased corporate viability.

For instance, changing suppliers may not be the best way to lower operating expenses, especially if your new provider skimps on quality. By looking at historic gross margins as well as expenses such as service calls and consumer complaint handling, however, you may be able to determine which of your lower-cost supplier options will prove most suitable for your needs.

It's Time to Forgo Generic Accounting

Unfortunately, most companies only encounter their gross profits as part of other figures like net income or even EBITDA. While it's critical to be conversant with your overall operating profit, this alone can't hope to suffice, especially when you're attempting to analyze specific details.

Remember that gross profit and other KPIs are most effective when they're used together. For instance, it's quite possible to have increasing gross profits yet overlook the fact that your gross profit margin isn't changing as much as you'd like. If your costs of goods sold decrease slightly more than your net sales decrease, you'll probably feel overjoyed to see your gross profits increase. Without taking the next step and calculating gross profit margins in such an instance, however, you'd miss the fact that you're not really improving your marketing or operating efficiency by more than few percentage points. When levering financial data to make intelligent business decisions, the aggregate of this information will likely help outline the greater picture.