As a CFO at a growing startup, you see your latest quarterly report shows a spike in revenue, but something doesn’t add up—profits aren’t reflecting the expected growth. This is where understanding what gross profit is becomes crucial.
Gross profit gives you a clear picture of your company’s production efficiency and financial health by focusing solely on costs directly tied to production. By analyzing this metric, you can make informed decisions about pricing strategies, production efficiency, and overall profitability, ensuring you align with your business goals and financial targets.
Let’s look in detail at how gross profit is calculated and the role it plays in the financial system.
Definition of Gross Profit
Gross profit is the profit a business makes after subtracting the cost of goods sold (COGS) from total revenue. Essentially, it reflects the money left over from sales after covering the direct costs associated with producing the goods or services you sell.
Gross profit is sometimes referred to as gross income, gross revenue, or sales profit. It excludes fixed costs, such as salaries, rent, and utilities, focusing solely on variable production costs. This distinction helps you assess how well your company converts sales into profit and manages production efficiency more effectively.
The formula for Calculating Gross Profit
To calculate gross profit, use the following formula:
Gross Profit=Total Revenue−Total Cost of Goods Sold (COGS)
Learn more about how to analyze profit and loss statements.
Understanding revenue is straightforward. It is the total income your business earns in a period. However, COGS has many components which you should factor in while calculating gross profit. Let’s look at them.
Components of Cost of Goods Sold (COGS)
COGS includes all the direct costs associated with producing the goods or services you sell. Here’s a breakdown of what makes up COGS:
1. Materials and Parts
This includes the cost of raw materials and components used in manufacturing your products. For example, the cost of raw fabric for clothing or steel for machinery is part of COGS.
2. Labor Costs for Production Staff
Wages and salaries for employees directly involved in the production process are included. This covers the cost of workers who assemble, manufacture, or process your products.
3. Packaging and Shipping Costs
Expenses related to packaging materials and shipping products to customers are part of COGS. This ensures your products are properly prepared for sale and delivery.
4. Equipment Operation Costs (Utilities)
Utilities such as electricity, water, and gas used in operating production machinery are included. These costs are essential for maintaining production efficiency.
5. Processing Fees for Purchases
Fees associated with purchasing raw materials or components, including transaction and handling fees, are part of COGS.
6. Depreciation of Equipment
This cost is related to the wear and tear of production equipment over time. Depreciation is allocated as part of COGS to reflect the gradual expense of machinery.
7. Sales Commissions
Commissions paid to sales personnel based on the products they sell are included. This reflects the direct cost of driving sales and generating revenue.
Learn more about how to maintain these components in a chart of accounts.
By clearly understanding these components, you can more accurately calculate your gross profit and make informed decisions about pricing, production, and overall financial strategy. For further clarification let’s look at the components which you should exclude in the calculation.
Components Excluded from COGS
When calculating the Cost of Goods Sold (COGS), it’s important to understand which expenses are not included in this metric. COGS focuses solely on direct costs related to production, while other expenses fall outside this scope. Here’s what’s excluded from COGS:
1. Marketing Budgets
Costs related to advertising and promotional activities are not included in COGS. These expenses are part of your operating expenses and are accounted for separately.
2. Labor Unrelated to Manufacturing
Salaries and wages for employees not directly involved in the production process, such as administrative staff or sales teams, are excluded from COGS.
3. Insurance
Insurance costs, including general liability and property insurance, are not considered part of COGS. These are categorized as operating expenses.
4. Subscriptions
Fees for software subscriptions or industry publications are not included in COGS. These are treated as operational costs.
5. Equipment Leases
Costs associated with leasing equipment that is not directly involved in production are excluded from COGS. These are typically classified under general expenses.
6. Property Taxes
Taxes on property and real estate are not part of COGS. Instead, they are recorded as administrative expenses or other relevant categories.
If you are still confused, you can take the help of financial controllers. Learn more about what a financial controller does.
Now, let’s look at an example to understand how gross profit is calculated clearly.
Example of Gross Profit Calculation
To illustrate how gross profit is calculated, let’s look at a practical example involving a startup. Imagine you’ve recently launched a new e-commerce business selling handmade jewelry.
Scenario:
Revenue: $100,000
Cost of Goods Sold (COGS): $60,000
Components of COGS:
- Materials and parts (e.g., beads, metal wires): $30,000
- Labor costs for production staff (e.g., artisans): $20,000
- Packaging and shipping costs: $5,000
- Equipment operation costs (e.g., utilities for production): $3,000
- Processing fees for purchases (e.g., transaction fees): $1,500
- Depreciation of equipment: $500
Calculation:
To calculate gross profit, subtract the total COGS from your total revenue.
Gross Profit = Total Revenue – Total COGS
Gross Profit = $100,000 – $60,000
Gross Profit = $40,000
In this example, your gross profit is $40,000. This figure represents the revenue remaining after covering the direct costs of producing and selling your jewelry. It provides insight into your production efficiency and helps you assess whether your pricing strategy is effective.
Learn more about how you can automate these calculations with Bunker. Look at this tutorial.
Now that you can calculate gross profit let’s look at why gross profit is such an important metric for your business.
Importance of Gross Profit
Understanding your business’s gross profit has many advantages. Some of them are:
- Provides a Clear Understanding of Financial Health and Profitability: Gross profit shows how effectively your company is generating profit from sales after covering production costs. It’s a fundamental indicator of overall financial performance.
- Helps Evaluate the Efficiency of Labor and Resource Usage: By analyzing gross profit, you can assess how well your company manages production costs and labor. This helps identify areas for improvement in efficiency and cost management.
- Allows Assessment of the Profitability of Specific Products or Services: Gross profit analysis helps determine which products or services are most profitable, guiding decisions on pricing and product mix.
- Informs Major Business Decisions and Strategic Planning: Insights from gross profit can inform key business decisions, such as budgeting, investment, and strategic planning, ensuring that your company aligns its operations with financial goals.
Learn more about financial planning and analysis.
Knowing and analyzing gross profit can help you understand the intricacies of your financial health. Furthermore, if you want to reach deeper, gross profit margin can help you compare your performance with other businesses. Let’s look at it in detail.
Gross Profit Margin
The gross profit margin is a key financial metric that provides insight into the efficiency of your company’s production and sales processes. It reflects the percentage of revenue that exceeds the cost of goods sold (COGS), highlighting how well your business converts revenue into gross profit. Here’s how to calculate and interpret it:
Gross Profit Margin=(Gross ProfitTotal Revenue)×100
Example
Consider a company with a gross profit of $100 million and a total revenue of $500 million. Applying the formula:
Gross Profit Margin=(100 million500 million)×100=20%
This means the company retains 20% of its revenue as gross profit after covering the cost of goods sold.
Comparison Across Businesses
The gross profit margin allows for a more accurate comparison of financial performance across different businesses and industries. It helps assess how efficiently companies manage production costs relative to their revenue, offering a clearer view of operational effectiveness and profitability.
It also becomes an important metric while presenting your company’s financial data to investors to show comparison against competitors.
Also, explore these tips on fundraising.
By now, you have understood how important it is to calculate gross margin accurately. Errors can result in false interpretations and bad decisions. Further, you should be able to get a figure as and when needed. Relying on monthly or yearly reports might result in late decisions and lost opportunities.
Analyzing and correcting your business practices can improve your gross margin, making you competitive in the investor market. So, let’s look at the best practices while calculating gross margin in real-time.
Best Practices to Calculate Gross Margins in Real Time
These best practices will help you analyze your gross margin accurately and avoid pitfalls that make your finances weak.
Monitor Transaction-Level Outliers
Regularly review individual transactions to identify outliers in revenue and cost. For instance, if your company has a high volume of transactions with varying gross margins, investigate why some transactions are significantly more or less profitable. This helps in understanding underlying issues and trends.
Analyze Customer Transactions
If a customer makes multiple purchases throughout the year, examine why some transactions are less profitable than others. For example, if a customer’s 20 transactions out of 100 show lower margins, understanding these anomalies can reveal important insights about pricing, discounts, or product performance.
Regularly Update Your Calculations
Ensure that your gross margin calculations are updated frequently to reflect the most current data. This will provide you with accurate insights and help you respond quickly to any financial changes or trends.
Use Real-Time Data Analytics
Implement financial analytics tools like Bunker to gain real-time visibility into your gross margins.
Transaction-level visibility: Bunker helps you access transaction-level data and understand the reasons behind your financial metrics, allowing you to make more informed decisions.
For a deeper dive into your financial metrics and to uncover the reasons behind your numbers, Bunker provides advanced analytics and transaction-level visibility.
Customer Attribution Analysis: Bunker allows you to conduct customer attribution analysis, linking revenue and costs to specific customers or segments.
This is especially useful if your company serves various customer segments with differing profitability.
Improve Cash Flow Management: Utilize Bunker’s cashflow dashboards to move beyond simple bank balance accounting. Visualize and understand where your money is going and how to stretch every dollar.
Optimize billing and collections processes to reduce the days sales outstanding (DSO) and improve cash flow. Introduce early payment discounts or enforce stricter payment terms where necessary.With Bunker, you can seamlessly track and analyze your gross profit, identify areas for improvement, and make data-driven decisions that drive growth. Start your free trial today and see how Bunker can transform your financial insights!
