How Is Gross Profit Calculated?
The formula used to calculate gross profit is actually rather simple in nature. That said, it is still one of the most often quoted metrics in the business world. To calculate the gross profit of a business, a business owner will need to know their total revenue and the cost of goods sold (COGS).
Revenue is a word used to refer to all positive cash flows, not accounting for any of the related expenses.
Cost of Goods Sold is a term that refers to the direct cost of producing a product or service. This typically includes all materials and labor expenses that are involved.
To calculate gross profit, one should perform the following equations:
- Gross profit = Revenue – Cost of Goods Sold
Obviously, this formula is straightforward in nature. The hard part of calculating gross profit is figuring out the numbers one will use.
What Are Some Typical Mistakes When Calculating Gross Profit?
There are a few common mistakes that people make when calculating their business’ gross profit. Often, they will misstate their revenue or misstate the cost of goods sold.
While the terms profit, revenue, and income may be on occasion used interchangeably, these terms really do not refer to the same thing.
Revenue is a word that describes the total amount of money that a business has made. Income and profit are terms used to refer to revenue after it has been adjusted. Gross revenue will always be the largest figure.
When calculating a business’ COGS, the situation can get even more confusing. Labor and raw materials need to be accounted for, while distribution and marketing expenses will not be forgotten. The typical formula used for COGS is as follows:
- COGS = (Beginning Inventory Costs + Additional Inventory Costs) – Ending Inventory
To make sure one does not misstate his or her gross profit, it is important to be careful when calculating these inputs.
How Can Gross Profit Affect Business Operations?
Gross profit can help describe the financial health of a company. For instance, if a business is suffering from a negative gross profit, then it is obvious there need to be changes made.
In general, a business will want to have the highest profit it can manage. This means that in order to improve a company’s operations, it will need to either increase revenues or decrease the fixed cost of sold goods. Alternatively, a business owner may need to do both of these things in order to repair the company’s financial situation.
If a business’ gross profit goes up over a certain period of time, then this is indicative of the business recovering.
Gross profit is calculated by subtracting COGS from revenues. When a business owner plans his or her strategy moving forward, they should keep this figure in mind. Reviewing a company’s gross margins allows one to have an accurate view of his or her total sales, operating expenses, and other elements.