Do you know how profitable your small business’s operations are? You don’t have to be a financial expert to find out. You can calculate your gross profit to compare the funds you put into your business.
Gross profit definition
Gross profit is the revenue left over after you deduct the costs of making a product or providing a service. You can find the gross profit by subtracting the cost of goods sold (COGS) from the revenue. For example, if a company had $10,000 in revenue and $4,000 in COGS, the gross profit would be $6,000. This figure is on your income statement.
To calculate, use the gross profit formula:
Revenue – Cost of Goods Sold (COGS) = Gross Profit
To find the gross profit, you need to understand what revenue and cost of goods sold are. Revenue is equal to the total amount you make in sales. The calculation for cost of goods sold includes the expenses directly related to producing your products or services (e.g., raw materials).
You do not include operating expenses. Operating expenses could include rent, insurance, office supplies, interest charges, and tax payments.
How gross profit helps your business
What is gross profit in the context of your business? It is one of the many available basic accounting tools for small business. You can use this figure to check how efficiently you produce revenue. The greater your revenue and the lower your production costs are, the higher your gross profit is. Be careful not to confuse gross profit and profitability, as they are two separate metrics.
You can make positive changes to your business based on your gross profit. If you notice production costs are close to or above your revenue, make adjustments. You could decrease COGS by finding less expensive ways to produce goods or perform services. Or, you could increase revenue by expanding your marketing efforts.
Gross profit formula
Let’s look at an example. By comparing two competing businesses’ profits, you can see which spends more efficiently.
Mechanic Shop 1
A mechanic shop reports $15,000 in revenue for April. They spent $10,000 on the cost of goods sold.
Cost of Goods Sold: $10,000
You need to subtract the COGS from the revenue. For Mechanic Shop 1, you calculate $15,000 minus $10,000.
$15,000 – $10,000 = $5,000
The gross profit is $5,000.
Mechanic Shop 2
There is another mechanic in the area. Mechanic Shop 2 also reports $15,000 in revenue for April. But, their cost of goods sold is $7,000.
Cost of Goods Sold: $7,000
Again, you subtract the COGS from the revenue. For the second mechanic shop, you calculate $15,000 minus $7,000.
$15,000 – $7,000 = $8,000
The gross profit is $8,000 for April.
Here is a comparison of the two mechanic shops:
Mechanic Shop 1: $5,000
Mechanic Shop 2: $8,000
Mechanic Shop 2 has $3,000 more in gross profit. Looking at both mechanic shops’ figures, the second mechanic uses money more efficiently. That means that Mechanic Shop 2 spends less money to produce a similar level of revenue as Mechanic Shop 1.
Gross profit helps you record the costs required to produce revenue. When the cost of goods sold increases, gross profit decreases. You are left with less money for operating expenses. And, when the cost of goods sold decreases, your gross profit increases. You are left with more spending money for business operations.
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This article has been updated from its original publish date of August 24, 2012.This is not intended as legal advice; for more information, please click here.