Gross profit is your total sales, less the direct expenses required to achieve those sales.
Gross profit allows you to evaluate your business at any given moment, and track its growth and efficiency over time.
Gross profit differs from net profit. When business owners talk about their bottom line, they refer to their net profit. Net profit subtracts more than direct costs from total sales. Net profit subtracts operating expenses, interest, taxes, and direct costs.
While net profit illustrates the overall profitability of your business, gross profit remains a helpful metric you can use to improve efficiency and drive success over time.
How do you calculate gross profit?
You can calculate your gross profit with a simple equation:
Sales – Cost of goods sold = Gross profit
Or put another way:
What you have been paid – what you must pay = Gross profit
Sales is the most straight forward variable in the equation. Multiply the number of units sold by the price you sold the units for, and you have your sales.
To have a proper accounting of gross profit you must track and understand your invoices.
For example, if you sell 500 hammers for $10 each, your sales are $5,000.
Any promotional discounts or returns will adjust your sales downward.
Cost of goods sold (COGS) leaves room for interpretation, but will become a fixed equation for your business once you decide on the elements to include. COGS includes the direct costs associated with selling your products or services.
Direct costs include both fixed and variable costs associated with selling your products
Continuing with the hammer example, fixed costs included in COGS likely include:
- Payroll and property taxes
- Employee salaries
- GST and other tax
Variable costs associated with selling hammers include:
- Hammer materials
Both fixed and variable costs must be included in your COGS to accurately calculate your gross profit.
If your COGS for selling a single hammer is $6 per hammer, your cost of goods sold for 500 hammers is $3,000. Calculate your gross profit for a $10 hammer as follows:
$5,000 – $3,000 = $2,000.
The hammer example leaves you with a gross profit of $2,000 on a sale of 500 hammers.
How is gross profit helpful?
Why is a $2,000 gross profit on your hammer sales helpful to know when your bottom line must consider additional expenses?
Gross profit helps you identify cost saving opportunities on a per product, or per service basis. You can dig into individual elements of COGS to understand where you can pull cost out of your supply chain and operations.
First, consider your fixed costs. If you can find cheaper rent, insurance, or other fixed fees, your gross profit will increase.
Regarding variable costs, efficiencies and cost savings will also help increase your gross profit. For example, assume your gross profit is slightly negative, and you currently pay sales reps 10% commission on each hammer sale. Lowering commission to 9% will reduce your variable costs and positively impact your gross profit.
If lowering commission is not an option, consider alternative COGS variables. Ask your material supplier for a discount if you agree to buy a larger quantity with each purchase. If the supplier agrees, your variable cost will decrease. Carriers and freight forwarders are often willing to extend discounts for increased volume.
Because gross profit includes COGS that are directly tied to the sale of your goods, you can evaluate expenses tied to sales at a granular level.
If you only look at your bottom line, or net profit, identifying simple ways to cut costs in your business becomes difficult.
How to use gross profit in business planning
When you sit down to evaluate your business success and plan your future, your gross profit calculation will empower you to make wise business decisions.
Customers buy during promotions because its an opportunity to buy your product at a lower price. But, promotions come at a cost to your business. They lower the overall sales variable in your gross profit formula.
Using the gross profit formula, you can determine whether or not your business can afford to run a promotion.
Assume you want to offer a 20% discount on your hammers for a limited time. A 20% discount on a $10 hammer equals a $2 discount.
During the promotion, your sales per hammer is $8. Use the gross profit formula to understand how the promotion will impact each sale:
$8 – $6 = $2.
During the promotion, you continue to earn a profit on each sale, but the gross profit is only $2 per hammer, instead of the typical $4 per hammer.
With your gross profit known, you can make an informed decision regarding how long to run the promotion, the number of hammers you need to sell to make the promotion worthwhile, and have confidence that each sale remains a profitable sale.
Don’t arbitrarily pick a discount for your promotions. Use the gross profit formula to strategically select promotional discounts.
Getting to profitability
Many businesses cannot turn a profit in the early days. Often, upfront capital is needed to bring the business to scale before profitability becomes a possibility.
But, running an unprofitable business is not a long term solution. Use the gross profit formula as a guide to profitability.
To illustrate, dig into the hammer COGS a little more. Assume your $6 COGS is broken down by the following costs per hammer:
- Payroll and property taxes: $1
- Employee salaries: $1
- Rent: $1
- Insurance: $1
- Hammer materials: $1
- Shipping: $0.33
- Fees: $0.33
- Commissions: $0.34
Assume your $1 hammer material rate is based on your buying 500,000 units per order. That’s a $500,000 investment. You may not have been able to afford that in the early days or your business.
If you only had $20,000 to start up your business, you couldn’t have afforded 500,000 units. If your supplier charges $2 per unit for orders under 500,000, $4 per unit for orders under 50,000, and $6 per unit for orders under 10,000, your first order will be less than 10,000 units.
In this case, your COGS per hammer increases significantly. Instead of $6 per hammer, your COGS is $11 per hammer. Apply this scenario to the sale of one hammer at the standard $10 rate:
$10 – $11 = -$1
You lose $1 on each hammer sale. At this rate, the more hammers you sell, the quicker you lose money. This model is not sustainable.
Although it doesn’t appear you have a sustainable business model, you can use the gross profit formula to understand how to achieve profitability.
For starters, increase the price of your hammers by $1, and you make it to the breakeven point:
$11 – $11 = $0.
Now, see if you can reduce fixed or variable costs. Try cutting commissions in half, and forego your salary to get your business off the ground. That cuts your COGS by $1.17 for each hammer sold:
$11 – $9.83 = $1.17
By minimally increasing your sale price, and reducing some of your costs, you have now made it to profitability even when you don’t have the buying power to get a steep discount from your supplier.
Gross profit helps you plan, forecast, right size, and scale your business. Regardless of your business size or season, learn how to calculate gross profit as it applies to your business.
You can’t outgrow the gross profit formula
As simple as the gross profit formula is, it will forever apply to your business and scale with you.
Sharon Price John is the CEO of Build-A-Bear Workshop, the experiential retailer where children come to a store and build their own teddy bear.
When Price John joined the company in 2013, the company had become a very successful brand with revenues in the $400 million dollar range. As successful as the brand had become in its young history, its cost structure was off. The company suffered a $60 million dollar loss in the year immediately preceding Price John’s taking the CEO job.
Price John believed in the brand, and was determined to right the ship through a gross profit analysis. Just like the hammer example above, she taught her employees to evaluate the COGS associated with each individual teddy bear.
She recently recapped this exercise in an interview on the Podcast Without Fail:
“I’m like, “But let’s look at that [bear model]. Is there something about that [bear model] that keeps it from hitting the [profit] margin goal?” Because there’s always going to be something that doesn’t sell and you have to mark it down. So you actually need to be pretty aggressive about hitting that going-in [profit] margin goal. And I’m like, “Let me look at this.”
And I say — they’re like, “But it’s — but it’s the average. It’s the average.” I’m like, “You can’t — you can’t do it. I get to manage the company on the averages. You can’t.” Right? You got to — so we — they brought it — they brought out this particular one. It was a mermaid outfit for a bear, right? So cute. I’m like, “How far are you off?” And this is, you’re down in the itty-bitty details here. They’re like, “We’re like, two or three cents off.” I’m like, “Why is there padding in the mermaid’s bra? It’s a bear, guys. I’m like, “Between your materials and these two operations, there’s three cents. Take it out.”
Notice how Price John instructed employees to examine gross profit on the individual bears the company sold. The company previously managed the business from an entire balance sheet perspective. She referred to that strategy as “the averages”. Price John trained her employees to get granular. She urged them to look at each element of their COGS.
Guess what? It worked.
Under Price John’s leadership, the company erased the $60 million loss in 2012, and returned to profitability in her first year.
Whether you are just getting started, or you manage a publicly traded, multi-million dollar enterprise, the gross profit formula remains the same.
Use it to understand your business. Use it to rightsize your business. Use it to grow your business, and make your business successful.