Gross profit and your business: What does it mean?
Monday, 10 October 2016 14:33
If you run your own small business, you will have come across a number of different ways of evaluating your profitability. One such method is gross profit, and gross profit margins. While they may not be the only figures you are using to check the health of your enterprise, they may still be important.
Here's what you may need to know to interpret them properly.
What is gross profit?
Gross profit can be a method used by businesses to analyse their profitability at using a given amount of labour and supplies1. In simple terms, this is how much money you make from selling your inventory (revenue) when compared to how much you paid for it (cost of goods sold), without including fixed costs such as rent, fixed labour costs and so on2. This assumes that such expenses would be the same, regardless of the level of output on your enterprise, i.e. you could sell 500 or 5,000 of something, but the fixed salaries you pay your sales assistants is the same regardless; thus, it isn't considered.
For example, if you were a clothing retailer who spent $1,000 on clothing stock each week, and sold them all for $1,200, you would have a gross profit of $200. You may not consider the costs of paying standard rostered shop assistants, because this would be the same whether you sold everything in the store, or nothing.
On the other hand, you may be in an industry where labour isn't a fixed cost, and is directly related to how much revenue you gather. In this case, the cost of labour would be a variable cost and you would factor into your gross profit.
For example, if you decided to have a stall at a festival and had to pay your workers overtime, that would be considered in your gross profit calculation, as your sales are now directly tied to the amount you pay your workers. You buy additional inventory for the event for $1,000, manage to sell it all for $1,200, but the cost of keeping your staff there has cost you an additional $200. As a result, your gross profit (for that event) is now $0.
Gross profit vs net profit
An important distinction to make is the difference between gross profit and net profit. Net profit includes the fixed costs (or 'operating expenses') that gross profit ignores. As a result, it is sometimes considered a more accurate indicator of overall profit3.
What does it mean for your business?
However, this does not mean that gross profit has no use. As stated previously, it is a tool that can be used to analyse the overall profitability of your business. However, perhaps more usefully, it can be used to calculate your gross profit margins.
Gross profit margins are calculated by dividing your gross profit by your revenue. This is then presented as a percentage. For example, if you were to buy $1,000 worth of clothing and sell it for $2,000 in one week, your gross profit margin would be 50 per cent. In other words, you are making 50 per cent of the money you spent on inventory back as it is sold.
Both gross profit and your gross profit margin are important to keep an eye on, as you can have a growing gross profit, but a falling gross profit margin, which may result in financial difficulty for your business4.
In the above example, you would have a gross profit of $1,000 and a gross profit margin of 50 per cent in week one. In week two, you buy $2,000 worth of clothing but only sell it for $3,500. Your gross profit is now $1,500, which looks good, but your gross profit margin has dropped to about 43 per cent.
Generally speaking, the higher your gross profit margin is, the more efficient your business is at creating revenue from a certain amount of inventory - it is a direct reflection of how well-designed your processes and procedures are5.
What can you do to improve the gross profit margin?
Different acceptable gross profit margins may differ from industry to industry and business to business. However, you may find that your own gross profit margin is falling short of what you would expect.
If this is the case, there are two main methods of improving it: Increase your prices, or reduce your costs2.
Increasing your prices can be a dangerous gambit, as it may push customers away from your products due to the higher price point.
In the above example, you spent $1,000 on the week's stock, selling it for $1,200, making a gross profit of $200 and a gross profit margin of about 17 per cent. You may decide that this is not significant enough, and decide to increase your prices. You spend $1,000 on the same amount of stock, but try to sell it for $1,500.
If successful, you would end up improving your gross profit margin to 50 per cent; a significant improvement. However, if you found that fewer people were buying your products, you may only be able to sell half of your total stock, bringing your total revenue down to $750. This would end up being a negative gross profit of $250, or a 33 per cent gross profit margin loss.
This is a simple example; but improving your gross profit margin may be a case of finding the right balance of prices2.
Depending on what your costs actually consist of, reducing your costs can include a number of different strategies.
In the clothing retailer example, you might be able to renegotiate the deal with your supplier, reducing the purchase costs of your stock to $700 instead of $1,000. Even if you sold it for the same price ($1,200 by the end of the week), your gross profits would grow from $200 to $500, and your margin from 17 per cent to about 71 per cent.
You will note that by increasing the prices by $300 improved the gross profit margin to 50 per cent, but reducing the costs by $300 improved the gross profit margin to 71 per cent. This is why it is important to look at both sides of the equation; a change at one end may be more significant than a similar change at the other.
Gross profit and gross profit margins can be an important evaluation technique for your business, and sometimes improving it can cost additional capital than you have easy access to.