If you manage your business finances regularly, the most important thing to focus on is profitability. Understanding gross profit and calculating it consistently is key to building and growing your business.
This guide will explain what gross profit is, how to calculate it, what the “cost of goods sold” means, and why these concepts are important for your business’s future.
What Is Gross Profit?
Gross profit (GP) is the revenue from sales minus the costs to make those sales happen. The costs related to sales are called “Cost of Goods Sold” (COGS), which is usually shown as a separate line on your income statement.
GP tells you how much your company would make without considering administrative costs or other expenses not directly tied to the product or service you sell.
To understand gross profit better, you need to know about your expenses.
Expenses fall into two categories: fixed and variable costs. Fixed costs are operating expenses that stay the same each month. They’re often grouped under “Sales, General & Administrative” (SG&A).
Variable costs, or COGS, include all other expenses related to making sales.
Fixed cost examples (SG&A):
◦ Rent
◦ Office Phones
◦ Salaries
◦ Employee Benefits
◦ Insurance
◦ Payroll Taxes
Variable cost examples (COGS):
◦ Utilities Not Fixed
◦ Hourly Labor
◦ Packing and Shipping
◦ Equipment
◦ Depreciation
Cost of Goods Sold
COGS on an income statement includes all expenses a business incurs to produce, source, and deliver a product to customers. This total is subtracted from the company’s revenue to find the gross profit.
COGS covers everything from raw materials to shipping costs but does not include marketing expenses or overhead. However, it does include labor costs for those who make and assemble the final product.
Understanding COGS is vital because it represents the real cost of running the business. If COGS goes up, gross profit goes down. Knowing these costs helps managers and investors see the company’s financial health clearly.
Calculating GP
The gross profit calculation is one of five equations used to measure a company’s profitability.
To find GP, subtract the cost of goods sold (COGS) from total revenue.
For example, if you produce coffee beans, you’d add up all the COGS—like purchasing raw beans, utility costs for roasting, labor for packaging, and shipping costs to customers.
If your sales revenue for the month is $800,000 and your COGS is $600,000, your gross profit for that month would be $200,000.
The equation looks like this:
Gross Margin
Gross margin is the gross profit expressed as a percentage of revenue and is calculated by dividing the gross profit by the sales or revenue and then multiplying by 100.
Let’s use our coffee bean manufacturing example again. We would complete the formula by inputting the gross profit and dividing it by the revenue, multiplying it into a percentage.
Therefore, every dollar of coffee bean sales generates about 25% gross margin.
There are two ways to improve your gross margin. A business can increase its product price or lower the variable costs associated with producing these products.
Long-Term Effects
Using gross profit as a metric helps manage an organization’s labor and materials more effectively during production. It allows you to pinpoint areas to cut costs and boost revenue when planning.
“We look at gross profit margins on a weekly basis to be adaptable and pivot at speed while providing proactive leadership and fact-based decision making,” says Claude Compton, founder of Pave Projects. “This regularity allows the business to ride out changing tides and isolate any issues before they become a long-term problem.”
By regularly monitoring profit margins for each area of your business, you can gather valuable data to identify and scale the most profitable parts of your organization.
About FINSYNC
FINSYNC is a leading financial technology company dedicated to empowering entrepreneurs through an all-in-one platform that manages banking, payments, cash flow, payroll, accounting, and more. Through its CO.STARTERS Program, FINSYNC is committed to building stronger communities by empowering entrepreneurs with the tools, resources, and networks they need to succeed. For more information, visit FINSYNC.com.