There’s lots of financial terms that you need to know about when you’re running a business and one of the most important of them is gross profit. But what is gross profit and why do businesses need to understand it?
We’ll cover all of that in this guide to gross profit, including:
- What is gross profit?
- How to calculate gross profit
- Gross profit margin formula
- Gross margin profitability
So here’s everything you need to know about gross profit.
What is gross profit?
Gross profit is a financial metric that represents the amount of money that a company earns from its sales revenue after deducting the cost of goods sold (COGS). In other words, gross profit is the difference between revenue and the cost of producing and delivering the products or services that generated that revenue.
Calculating gross profit
To calculate gross profit, a company subtracts its cost of goods sold from its revenue. The cost of goods sold includes the direct costs of producing or acquiring the products, such as raw materials, labour, and shipping. Gross profit does not take into account any indirect costs, such as marketing or overhead expenses. We’ll go on to cover the gross profit equation itself shortly but first it’s key for business owners to understand why this metric is so important.
Why is gross profit important for businesses?
Reflects operational efficiency
Gross profit is an important metric because it reflects the efficiency of a company's operations. If a company has a high gross profit, it indicates that it is generating revenue at a much higher rate than it is spending on the production and delivery of its products or services.
This suggests that the company is operating efficiently and has a healthy bottom line.
Used to calculate your gross profit margin
It is used in several financial ratios and metrics, such as gross profit margin, which is the ratio of gross profit to revenue. Gross profit margin is an important indicator of a company's profitability, as it shows the percentage of revenue that is left over after deducting the cost of goods sold.
Necessary for accurate income statements
To create an accurate income statement, it's crucial to understand the difference between gross and net profit. Failing to differentiate between the two can lead to inaccurate financial statements that present an unrealistic picture of your business. The accuracy of financial documents is crucial for making informed business decisions, and incorrect profit information can significantly affect the management's decision-making process.
Can help identify way to minimise costs and increase net profit
While gross profit can help identify ways to minimise costs and increase prices, net profit is a more accurate indicator of a company's financial health and available cash. When investors consider investing in a company, they typically look at the net profit to determine if it's worth investing their money.
However, it's essential to note that if your net profit is less than your gross profit, it indicates that your business expenses are higher than your revenue. This information can help you identify areas where you can cut expenses and improve your profitability. Ultimately, understanding the values of gross and net profit is critical to assessing the financial health of your business and making informed decisions to ensure long-term success.
What does gross profit show?
Small businesses need to know the meaning of gross profit for several reasons:
- Measure profitability: Gross profit is an important measure of profitability for small businesses. It helps them understand how much money they are making after deducting the direct costs of producing and delivering their products or services. It’s also useful for applying for R&D relief, to deduct 130% of your qualifying costs from your yearly profit.
- Evaluate pricing strategy: Small businesses often have limited resources, so it's important for them to set the right prices for their products or services. By understanding their gross profit, they can set prices that cover their direct costs and generate a profit.
- Optimise operations: Small businesses often have limited resources, so it's crucial for them to optimise their operations to maximise profitability. By monitoring their gross profit, they can identify areas where they can reduce costs, negotiate better prices from suppliers, or improve production processes.
- Manage cash flow: Small businesses need to manage their cash flow carefully to ensure they have enough funds to cover their expenses. Gross profit can help them understand how much money they are making from sales, which can help them manage their cash flow more effectively.
- Make informed decisions: By understanding their gross profit, small businesses can make informed decisions about their operations. They can use this information to identify areas where they can invest in their business, such as marketing or product development, or to make changes to their operations to improve profitability.
That’s why you need to know what gross profit means, as well as for important tasks like when you'll have to submit your profit or loss for Corporation Tax.
How to Calculate Gross Profit
We’ve explained why small businesses need to understand their gross profit to measure profitability and make informed decisions. Calculating gross profit is a straightforward process that involves subtracting the cost of goods sold from revenue. In this blog post, we'll explain how to calculate gross profit.
The first step in how to work out gross profit is that small businesses need to determine their total revenue. Revenue is the total amount of money that a business earns from the sale of its products or services.
It's essential to have an accurate record of all revenue earned during a given period. This information can be found in the company's sales records or financial statements.
Calculate the Cost of Goods Sold (COGS)
Next, small businesses need to determine their cost of goods sold (COGS). The cost of goods sold is the direct cost of producing or acquiring the products that a business sells. This can include the cost of raw materials, labour, shipping, and other expenses directly related to producing the products or services.
To calculate the COGS, small businesses can use the following formula:
COGS = Beginning inventory + purchases - ending inventory
Beginning inventory refers to the value of the products or materials that a business had at the beginning of the period. Purchases refer to the value of the products or materials that a business acquired during the period. Ending inventory refers to the value of the products or materials that a business has at the end of the period.
Calculate Gross Profit
Once small businesses have calculated their revenue and COGS, they can work out their gross profit calculation. Gross profit is the difference between revenue and COGS. The formula for calculating gross profit is:
Gross Profit = Revenue - COGS
For example, suppose a small business generated £100,000 in revenue during a given period and had a COGS of £60,000. In that case, the gross profit would be £40,000 (£100,000 - £60,000).
Gross Profit Margin Formula
Gross profit margin, which is the ratio of gross profit to revenue, is a useful metric that can be derived from gross profit. It enables comparison of a company's production efficiency over time.
Merely comparing gross profit figures from year to year or quarter to quarter can be deceptive, as gross profits can increase while gross margins decline. This trend is concerning and can potentially put a company in a difficult position.
The formula for calculating gross profit margin is:
Gross Profit Margin = (Gross Profit / Revenue) x 100
For example, suppose a small business had a gross profit of £40,000 and generated £100,000 in revenue during a given period. In that case, the gross profit margin would be 40% (40,000 / 100,000) x 100).
Gross Margin Profitability
Gross margin profitability, also known as gross profit margin, is a financial metric that shows how much profit a company is generating from its sales revenue after deducting the cost of goods sold (COGS).
It is calculated by dividing the gross profit by the revenue and multiplying the result by 100 to express it as a percentage.
Gross margin profitability is an important measure of a company's profitability, as it indicates how efficiently a company is using its resources to produce goods or services. A higher gross margin profitability means that a company is generating a greater percentage of profit from its sales revenue, which is a positive indicator of its financial health.
For example, if a company has a gross profit of £100,000 and its revenue is £500,000, its gross margin profitability would be 20% (£100,000 / £500,000 x 100). This means that the company is generating 20 pence of gross profit for every pound of revenue it earns.
Gross margin profitability can also be compared with industry benchmarks or competitors to determine how well a company is performing relative to others in its industry. It can help identify areas where a company may be overpaying for materials or where it may need to adjust pricing to maintain or increase profitability.
Key takeaways on gross profit
In summary, gross margin profitability is a key financial metric that shows how efficiently a company is generating profit from its sales revenue. It is an important measure of a company's financial health and can be used to compare performance with industry benchmarks and competitors.