Written by Stephen Beard, Managing Director of Plyo Bookkeeping, a Vancouver-based bookkeeping firm.

Introduction

Welcome to our first blog aimed at helping small business owners interpret and understand their financial statements. This week we’ll be focusing on understanding gross profit, what it means, how to calculate it and how to improve it.

What is Gross Profit?

Gross profit is the profit a company makes after deducting direct costs from revenue, but before deducting general overheads. Direct costs can also be thought of as variable costs, as they increase or decrease directly in response to the total amount of goods sold or produced. Overheads can be thought of as fixed costs, as they will stay the same (at least in the short run) regardless of the sales volume.

There is no hard and fast rule as to what defines a direct cost vs an overhead, rather it depends on the specific context and industry of the business. The metric is clearest and most obvious in manufacturing businesses, where certain expenses clearly relate to the manufacture of the product (e.g. factory labour, materials, factory rent) and certain expenses are not directly related to the product (e.g. marketing costs, administration staff expenses, head office rent).

For service businesses, direct costs would be staff who work solely in the delivery of the service, and any costs that only exist because of a customer. For example, as a bookkeeping firm we must pay for a software subscription for each client. This software expense only exists because of the sale of bookkeeping services to the client; hence it would also be a direct cost. However, expenses to employees who exist solely to provide internal admin for a business (such as a virtual assistant) are not directly related in the sale of services, and so would be considered an overhead.

How to Calculate Gross Profit

Once you’ve defined your direct costs, also called your Cost of Goods Sold (COGS), your gross profit is calculated using the formula:

Gross Profit = Revenue – Cost of Goods Sold

Defining what is a direct cost (COGS) and what is an indirect cost (Overhead) is the tricky part; the actual calculation is very straight-forward. Let’s look at an example:

A restaurant turns over $70k in a month. During that month it has $20k of expenses in food ingredients, $15k in restaurant staff salaries and $5k in utilities. The gross profit would be calculated as follows:

Gross Profit = $70k (Sales) – $20k (food) – $15k (direct wages) – $5k (utilities)

Gross Profit = $30k

Even in this simple example it’s useful to think about what was left out and why. Notice for example that the restaurant rent was not considered a direct cost. The reason for this is that rent is fixed, regardless of how much food is sold at a restaurant. One of the main reasons to calculate gross profit is so that you can then calculate your gross profit margin. Your gross profit margin should be comparable between different months, even if your revenue fluctuates. This is because gross profit is calculating your profit after only the variable costs (which directly increase or decrease in relation to sales volume) have been deducted.

How to Calculate Gross Profit Margin

Gross profit margin is just your gross profit expressed as a percentage of revenue. It’s calculated as follows:

Gross Profit margin = (Gross Profit/Revenue) x 100

In our restaurant example, gross profit margin would have been:

Gross Profit Margin = ($30k/$70k) x 100

Gross Profit Margin = 42.86%

What my Gross Profit Margin Says About my Business

Your gross profit margin conveys a lot of information. Because it’s measuring the profit after variable costs are deducted, you can see how much additional revenue you’d need to add to cover your overheads (fixed costs) and hit your profit goals. If you also know how much it costs in marketing spend to get that additional revenue, then you’re really beginning to understand the how your business works.

A high gross profit margin is good, but what defines good really varies based on your industry. The easiest way to assess how you’re performing is to use benchmarking, where you compare your gross profit margin against the industry average.

If your gross profit margin is low, then you either need to increase your prices or decrease your variable costs. Again, benchmarking your sales price and COGS is also a very useful exercise in understanding which area of your business you should be focusing on.

Quantity and Quality

Sometimes a business can appear to have a lower than industry average gross profit margin, but there sales pricing and COGS seem in line with industry norms – what’s going on?

While your labour costs are variable, they are not perfectly variable. If you have manufacturing staff working at 50% capacity, then your labour costs per unit produced will be much higher. This is a common situation, which is why increased sales volume can often increase the gross profit margin.

The Trade Off – Gross Profit vs Gross Profit Margin

While a high gross profit margin is important, it’s not the be all and end all. If you have a very high GP margin, then it’s very likely that your pricing is on the high end. This can be great for building a small and highly profitable business, but it can also reduce the total volume of your sales. A very high sales volume at a lower price can result in more gross profit as measured in cold hard cash, even if the gross margin is lower.  

Deciding between a high volume/low margin or lower volume/higher margin business model is a long-term strategic decision, and there is no right or wrong answer as to which is the better approach for your company. Regardless of which business model you choose, monitoring gross profit and gross profit margin is essential.