Calculating Gross Profit
A Step-by-Step Guide to Calculating Gross Profit (Formula and Examples)
According to the U.S. Bureau of Labor Statistics (BLS), 20% of new businesses fail during the first two years of starting, and 45% during the first five years.
While these closures can be attributed to carrying too much inventory, expanding too fast, incorrectly managing cash flow can play a detrimental role. This is where calculating gross profit comes into play.
Gross profit allows businesses to assess their profit margins and pinpoint areas for growth. With this information, companies can make data-driven decisions and increase their chances of succeeding.
Thankfully, Upscribe is here to help. We’ll provide a step-by-step guide to calculating gross profit, including formulas and examples of how to apply it effectively. Let’s get started.
What is gross profit?
Gross profit refers to the profit earned by a company after subtracting the costs of producing and selling its products or services. It’s typically listed on a company’s income statement and can be alternatively referred to as gross income or sales profit.
To calculate gross profit, simply subtract the cost of goods sold (COGS) from your revenue. For example, if a company has $20,000 in revenue and $8,000 in COGS, the gross profit would be $12,000.
Here’s the gross profit formula:
Revenue – Cost of Goods Sold (COGS) = Gross Profit
It’s important to remember that revenue refers to the total amount generated from sales, while COGS includes only expenses related to the product or service (raw materials). Operating expenses like rent, cost per conversion, and office supplies would not be included.
Applying the gross profit formula
Now that we have our formula for calculating gross profit, it’s time to put it into action. Here are some examples to gain a better understanding of how to apply these concepts in your own business:
Calculating gross income
Imagine a coffee shop called “Bean There, Done That,” it’s been in business for six months. The owner, Jane, wants to calculate the gross profit for the past three months to assess her financial performance and forecast inventory.
The first step is to gather information on the shop’s revenue for the last three months, including all the sales of coffee, pastries, and other items. Next, Jane has to determine the cost of goods sold for “Bean There, Done That.”
Jane has calculated that the revenue is $50,000 and the COGS is $30,000. With this breakdown, Jane can now use the gross profit formula to calculator the business’s gross profit:
Gross Profit = Revenue – COGS
Gross Profit = $50,000 – $30,000
Gross Profit = $20,000
Calculating daily gross profit
Using the same example, let’s calculate the daily gross profit for the above business. Jane sells a cup of coffee for $4, the cost of making one cup of coffee, including coffee beans, milk, and other ingredients, is $1.50. Jane sells 300 cups of coffee daily.
First, let’s calculate the revenue:
- Revenue per cup = $4 (selling price)
- Total Revenue = Revenue per cup x Number of cups sold daily
- Total Revenue = $4 x 300 cups = $1,200
Next, let’s calculate the cost of goods sold:
- Cost per cup = $1.50
- Total Cost of Goods Sold = Cost per cup x Number of cups sold daily
- Total Cost of Goods Sold = $1.50 x 300 cups = $450
Now, we can calculate the gross profit:
- Gross Profit = Total Revenue – Total COGS
- Gross Profit = $1,200 – $450
- Gross Profit = $750
So Jane’s daily gross profit from selling coffee is $750.
Annual Recurring Revenue (ARR)
One of the most popular ways to calculate subscription revenue is through Annual Recurring Revenue (ARR). This method is perfect for customers who have long-term contracts. Here are some examples:
- If you have a single customer with a two-year contract valued at $14,000, their ARR would be $14,000/2 = $7,000.
- If you have ten customers paying $2,000 per month, you would first multiply ten by $2,000 to get your total monthly income of $20,000. Then, you would multiply your monthly income by 12 to calculate your total ARR: $20,000 x 12 = $240,000.
Gross Profit vs. Net Profit
Net profit represents the earnings that a company generates after deducting the cost of goods sold as well as operating, interest, and tax expenses. Essentially, it’s the amount of profit that remains once all the expenses have been taken into consideration.
While gross and net profit are necessary financial metrics, they represent different aspects of your financial performance. Whereas gross profit is the amount of revenue you have left after accounting for COGS, net profit considers every aspect, such as:
- Operating expenses
- Income taxes
- Depreciation costs
To calculate net profit, take a look at this formula below:
- Net Profit = Total Revenue – Total Expenses
Breaking the formula down even further, consider the following:
- Net Profit = Gross Profit – Operating Expenses – Other Business Expenses – Taxes
In summary, gross profit sheds light on how efficient a company is at managing its production costs. On the other hand, net profit provides valuable insight into how all aspects of a business are running, it’s why it’s often referred to as the “bottom line.”
Why is gross profit necessary?
Let’s look at three examples of why gross profit is essential in running a successful business:
- Gross profit helps measure how efficiently companies produce products or services. A high gross profit means they’re making profitable decisions, while a low or negative gross profit indicates a need to cut costs or rethink strategies.
- Tracking gross profit over time helps companies understand how well they manage costs. A decrease in gross profit signals a problem that needs addressing, while an increase shows that recent changes are working and should continue.
- Assessing a company’s gross profit gives insight into how effectively they utilize labor, raw materials, and other supplies. It gives businesses a head start in inventory planning in terms of what’s needed.
How to calculate gross profit?
Here’s the fun part. Now that we’re familiar with the formula for calculating gross profit, let’s unpack the essential details:
What makes up the cost of goods sold (COGS)
To utilize the formula correctly, you need to understand what makes up COGS. For those unsure, the cost of goods sold refers to all the direct costs and expenses involved in producing or delivering your goods and services. This would include:
- Shipping costs
- Raw materials required for manufacturing
- Labor costs taken on in production
- Production equipment costs
- Utilities used in your production facility
COGS does not include indirect costs like staff salaries or sales and marketing.
What makes up revenue
Revenue is the total income your company generates from selling products or services. It tells you how much money you’ve earned from sales. It’s worth remembering revenue excludes the costs of running your business (like taxes, etc).
Revenue can be reported as net sales since it can include deductions and discounts from deductions and damaged goods.
Putting it into action
Now that you have all of the relevant tools, let’s do a step-by-step guide on calculating gross profit:
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Step 1: Determine the cost of goods sold
Let’s say you own a skincare brand and made a profit of $5,000 selling your products online. To calculate your cost of goods sold (COGS), add up all the expenses associated with manufacturing and selling your skincare products.
This would include:
- Raw materials (including bottles, jars, essential oils, etc)
- Website subscription fees and tools such as Upscribe to improve customer experience
- Shipping costs
- Manufacturing costs
By adding together your expenses, you can determine your COGS.
Step 2: Determine the revenue
Using the skincare brand example, calculate the revenue amassed from selling skincare products within a desired timeframe. For example, to determine the gross profit in Q1 of 2022, add the profits together from sales in January, February, and March of 2022.
Step 3: Bring everything together
Using the results from steps 1 and 2, you can now calculate your gross profit for Q1.
How to increase your gross profit?
If you want to increase your gross profit (and who wouldn’t), efficiency is your answer. Take a look at these examples to help:
- Increase prices: While this seems obvious, it could potentially hinder your sales in the long run. High prices may deter potential customers from making a purchase. It could also negatively affect client relationships you have already formed.
- Decrease your cost of goods sold: If you know you’re onto a winning product or service, buying materials in bulk can offer volume discounts. Additionally, you can give employees more responsibility so you won’t have to hire more staff.
- Increase productivity: Making changes in the workplace can improve overall efficiency. Streamline processes and encourage collaboration to foster a more positive work environment.
According to research, a good gross profit for online retail is 45%, so if you’re around this area, you’re on the right track. Thankfully, by now you should have all the necessary tools to provide insight into your company’s performance.
To stay on the right track, Upscribe’s subscription management tool provides first-class customer support, easy-to-manage subscriptions, and out-of-the-box tools to help grow your business. Schedule a demo with us today to get started,