When it comes to business finance, there are a lot of terms, phrases, and buzzwords to wrap your head around. And while you don’t have to know each one inside out (you can leave that to us!), it does help to understand the important ones.
One such term we want more business owners to get to grips with is Gross Profit, and in this short post, we’ll explain what it is and why it matters.
What is gross profit?
Gross profit is a measure which helps you determine the profit your business makes on each sale before you deduct fixed costs.
Sometimes known as “gross margin” or “gross income”, gross profit is your sales revenue minus the cost of sales or cost of goods sold (i.e., the costs associated with production and sale of a service or product).
- For digital and professional services, these are mainly staff costs, as staff, on the whole, deliver the product being sold. Other costs, such as software used in delivering services, can also be included.
- For online retail, meanwhile, this will be the cost of manufacturing the goods, including the purchase of materials and labour. Additional costs, such as agents fees and payment processing fees (e.g. eBay or PayPal) should also be included.
Once you have the costs in question, you can calculate gross profit using this formula:
Gross Profit = Sales Revenue – Cost of Sales
So, why is it important?
In our experience, by tracking gross profit, you can take steps to revitalise the performance of your business, both in terms of operations and, as a result, profitability.
This is because gross profit helps to highlight the efficiency with which you’re managing labour, raw materials, and supplies throughout the manufacturing/service-delivery process.
If you’re consistently measuring your business’s gross profit, you can take steps to reduce the variable costs associated with the delivery of your product or service. For example, you could do this by switching suppliers, automating tasks, or streamlining your workflow.
Yet, without this information, you’re essentially flying blind. Those quick wins and marginal gains that drive efficiency and profitability will remain tantalisingly out of reach.
Calculating your gross profit margin
Once you have your gross profit figure, you can work it out as a percentage to get your gross profit margin. The magic formula for that is:
Gross Profit Margin = Gross Profit/Sales Revenue x 100
This percentage can then be benchmarked against other gross profit margins within your industry to gauge how your business is performing. It can also be used to challenge business performance internally and, when used well, drives conversations around the best and worst-performing revenue streams in a business and how to identify them.
Reporting on gross profit — start today!
The good news is, you can quickly analyse gross profit in Xero. And by setting up a reporting template, you can keep tabs on your gross profit percentage each month as one of your key business metrics.
But we do recommend that you have someone with experience check over your calculations to make sure everything is correct. Bad financial data can often be more dangerous than no data whatsoever!
—Do you want to get Xero set up right and working for you? Spark is a Gold Champion Xero Partner Accountant, working with over 100 businesses. Book a quick 15-minute discovery call to learn more.