Understanding your business

Gross profit and your business: What does it mean?

If you run a 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.

Here's what you need to know to interpret them properly.

Understanding gross profit

Gross profit is one method used by businesses to analyse their profitability. In simple terms, this is how much money you make from selling your inventory (sales revenue) when compared to how much you paid for it (cost of goods sold), without including fixed costs such as rent, fixed labour costs, insurance and so on.

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 salary you pay your sales assistant is the same regardless; therefore, 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 $2,000, you would have a gross profit of $1,000. You do 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.

Gross profit = Sales Revenue – Costs of Goods Sold
Sales Revenue $2,000
Costs of Goods Sold $1,000
Gross Profit $1,000

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 it 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 $2,000, but the cost of keeping your staff there has cost you an additional $1,000. The 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 (also known as net income). Net profit subtracts total costs, including the fixed costs (or 'operating expenses') that gross profit ignores. As a result, it is considered a more accurate indicator of overall profit.

Understanding the impact on your business

As stated, gross profit is a tool that can be used to analyse the overall profitability of your business. Perhaps more usefully, it can calculate your gross profit margins (also referred to as gross 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 is $1,000, but your gross profit margin would be 50 per cent.

Gross profit margin = (gross profit ÷ sales revenue) x 100
Gross Profit $1000
Sales Revenue $2000
Gross Profit Margin 50%

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 margin, which may result in financial difficulty for your business.

In the above example, you would have a gross profit of $1,000 and a gross profit margin of 50 percent in week one. If in week two, you buy $2,000 worth of clothing but only sell it for $3,200. Your gross profit is now $1,200, which makes your bottom line look good, but your gross profit margin has dropped to about 38 percent.

Generally speaking, the higher your gross profit margin is, the more efficient your business is at creating revenue from a certain amount of inventory – and this can be a direct reflection of how well-designed your processes and procedures are.

What can you do to improve the gross profit margin?

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 costs.

Increasing prices

Increasing your prices can be risky, as it may push customers away from products due to a higher price point.

In the above example, you spent $1,000 on the week's stock, selling it for $2,000, making a gross profit of $1,000 and a gross profit margin of 50 percent. You may decide that this is not significant enough, and increase your prices. You spend $1,000 on the same amount of stock, but try to sell it for $2,500.

If successful, you would end up improving your gross profit margin to 60 percent. 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 $1,250. This would end up being a gross profit of only $250. Your gross profit margin would also fall to just 20 percent.

This is a simple example, but improving your gross profit margin is a case of finding the right price point.

Reducing costs

Depending on what your costs actually consist of, there may be ways to reduce your costs to improve your margins.

For example, a clothing retailer might be able to renegotiate a deal with a supplier, reducing the purchase costs of stock to $700 instead of $1,000. If you sold goods for the same price ($2,000 by the end of the week), your gross profits would grow from $1,000 to $1,300, and your margin from 50 percent to 65 percent.

Note that by increasing the prices by $500 improved the gross profit margin to 60 percent, but reducing the costs by $300 improved the gross profit margin to 65 percent. 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.

The Bottom Line

Gross profit and gross profit margin can be important evaluation techniques for your business. Sometimes improving these can involve the investment of more capital than you have available. Chat to an IMB Bank Business Specialist to enquire about options available to you.

What are Fixed Costs and Variable Costs?

If you’re starting a business, fixed costs will form part of your budgeting commitments and can play an important part in your overall business plan. Your business will likely have different fixed costs to others, and you may also finance them in different ways. Let's take a closer look at the difference between fixed and variable costs.

What are Fixed Costs?

Fixed costs are often what they say on the tin: expense commitments that are ongoing and not dependent on the level of output your business produces. Examples of fixed cost include labour costs, rent, insurance and utility bills. The rent for your commercial premises is a good example, as this will generally remain fixed for your lease term.

What are Variable Costs?

Variable costs are the other side of the coin – expenses that are more difficult to predict. Every business is different and therefore variable costs can vary from one business to another. Variable costs can include transportation, or raw materials such as sugar, coffee and timber.

Some businesses prefer to have the majority of expenses as fixed costs, as they can be easier to budget for. There are a number of different ways to do this. For example, your internet and phone bills will be variable costs if you pay them on a pay-as-you-go basis. However, with a monthly plan, these can be changed to fixed costs.

Another example of a fixed cost is a business loan, which require a predictable repayment every month (subject to interest rate changes), so you know how much you will need to put aside in order to meet your obligations.  

Other fixed costs depend on the business you run. If you use a vehicle or fleet of vehicles, you will incur fixed costs for the insurance on this fleet, but your petrol costs will be variable due to the fluctuating nature of the price at the pump and kilometres travelled.

Budgeting for fixed costs

As discussed, one of the primary benefits of fixed costs is easier budgeting for your business. However, there will always be some variability. For example,  

if you purchase a new piece of equipment for $1,000, the purchase price will be a fixed cost that you can budget for. However, if that new piece of equipment then requires certain resources or personnel to run it and you haven't factored this in, then you may find that your budget is no longer an accurate representation of your costs.

Another common budgeting mistake is not allowing for adjustments in your fixed costs. On a weekly basis, your fixed costs are unlikely to change, but if you are planning to grow as a business, then your fixed costs may increase as you take on more staff or increase your activity. Reviewing your fixed costs regularly and shifting priorities may be an important pathway to the success of your business.

How to Get on Top of Your Costs

The right Business Account can make it easier for you to keep track of your costs and your upcoming payments. Having convenient and easy ways to transact and stay on top of your accounts can make all the difference. IMB has a range of business accounts that offer flexible solutions for managing your cash including high interest transaction accounts and solutions for managing your tax more effectively.

Go to Part 3: Running Your Business for how your bank can help with cash flow and keeping the books in order.

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Important Information

Important Information

This article has been prepared by IMB Bank and contains general information only. It is not intended to be relied on as advice. It does not take into account your objectives, financial situation or needs. You should seek your own legal,  financial, taxation or other professional advice before you make any decisions about your business. Consider the relevant Terms and Conditions or Product Disclosure Statement and Target Market Determinations before deciding whether to acquire any products or services offered by IMB Bank. Lending criteria, terms and conditions, fees and charges apply to IMB loan products.  

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