June 14, 2022
Most people know that profit is one of the most important ways to measure your success when you are in business. However, once you start investigating how to calculate profit, you might discover that there is more than one type, and it’s a little more complicated than just adding a percentage to your prices.
When your business is profitable, it’s a sign that things are going well. When profits increase over time, it’s a sign that your business is growing. But you still need to know how to calculate how much profit you’re making.
Let’s take a closer look at Gross Profit, which is one of the more straightforward accounting calculations related to profitability.
Gross Profit is the amount of money you make when selling goods or services after deducting the cost of direct labour and materials used to deliver the service or manufacture the product.
It does not take indirect costs like overheads and head office administration costs, so it’s not a complete picture of how well your company is doing. However, it is an excellent way to measure how efficient your production and operations processes are and whether your pricing system is accurate.
Calculating Gross Profit can also be very helpful when dealing with volatile pricing of goods and services you rely on in your business. When your Gross Profit on sales starts dropping, it’s usually because your cost of goods has increased, and it’s probably time to adjust your pricing accordingly.
Calculating Gross Profit is relatively easy, as long as you track your costs carefully in your Profit & Loss Statement. This QuickBooks report can be easily pulled and updated in real time with LiveFlow.
The Gross Profit formula is simple:
Gross Profit = total revenue – direct COG (Cost of Goods Sold)
Cost of Goods Sold is always things that are directly related to manufacturing a product or delivering a service. So, for instance, in a bakery, the ingredients used to bake cakes and bread would be part of your Cost of Goods Sold calculation. Or, in a mechanic’s workshop, car parts and fluids that are used to repair cars would be part of your Cost of Goods Sold.
You can calculate Gross Profit on a per-job basis by doing job costing. You can also calculate your total Gross Profit on a quarterly or annual basis to measure your average Gross Profit for the period you are measuring.
Some companies choose to “spot check” their Gross Profit on random orders throughout the year and do detailed calculations less frequently. However, some companies cost every job so that they can spot problems immediately. This depends a lot on how established your business is and how comfortable you are with your pricing and production efficiency.
When you are asking what is Gross Profit and how to calculate Gross Profit, you also need to understand the difference between Gross Profit vs net profit.
Gross Profit only accounts for direct labor and material costs. These are expenses that are specific to a particular order. However, we know that those are not the only costs you will incur when delivering products and services to your customers.
You will also have costs that are not specific to one order, like the cost of utilities for your building, salaries for support staff, office supplies and other overheads. You might also have corporate legal fees, consulting costs and marketing expenses.
All of those things need to be deducted from your Gross Profit to calculate net profit so that you know exactly how much money you have made for the quarter or year.
This is another important figure that you can use to measure your business’s success and operational efficiency. If your net profit is much lower than your Gross Profit, it might be time to adjust your pricing or tighten up your operations.
In the accounting world, when you’re asking questions like what is Gross Profit and what is net profit, it simply means that gross is a quicker, simpler calculation that only takes direct costs or deductions into account, while the net is what’s left when all expenses and costs are calculated and deducted from revenue.
Gross Profit will always be a larger number than net profit. Still, if you are running your business efficiently and pricing your products and services correctly, there shouldn’t be too much difference between gross and net profit.
Because net profit is a much more accurate picture of how much money your company actually puts in the bank, it’s usually what banks and other lenders will look at. So it’s always a good idea to keep a handle on your operating costs so you don’t cut into your profits too much.
One of the most common questions businesses ask when they’re investigating how to calculate Gross Profit is how much Gross Profit you should make. How much markup should you add to your prices to ensure that you’re making enough money? That really depends a lot on the type of business you have.
Some businesses might not be able to add a substantial percentage because the products or services they produce cost more. So even a smaller percentage would be larger in monetary terms. Other businesses rely on smaller margins and high volumes.
Other businesses, such as service businesses that have a lower Cost of Goods Sold, can probably add higher margins to their prices.
There are many factors involved in calculating your margins and how much gross and net profit you need to maintain and grow your company.
This is why it’s essential that businesses – especially those that are still establishing themselves and figuring out what their pricing should be – keep careful track of Revenue, Gross Profit and Net Profit. These figures will quickly tell you if you’re charging enough for your products and services or whether you need to make adjustments.