I sometimes find, especially with clients that are new to their business, that they don’t always fully understand the difference between net profit and gross profit, and what causes gross profit to fluctuate over time. When you talk about a business’s profitability it’s usually in relation to its net profit, but understanding gross profit and how it’s measured is equally important. Gross profit is the first level of profit that will appear on your income statement (profit and loss) and knowing how to improve this figure will increase your chances of maximising the overall profitability of your business. Simply put, gross profit equals net sales minus the cost of goods sold. Cost of goods sold can also be referred to as cost of sales if a business provides a service, rather than sells goods, and includes all the costs directly involved in delivering that service. Therefore, sales and the cost of goods sold are the two elements that can be changed to improve a business’s gross profit.
The simplest way to do this is to just increase your prices because this goes straight to your bottom line. A price increase of 10% will result in a 50 % increase of net profit for most businesses. By increasing your selling price and leaving your cost of goods sold unchanged, you increase your gross profit. But most businesses can’t simply increase their prices as a way to be more profitable because their customers will just leave them. If you increase your prices hoping no one will notice and also have no marketing to justify and explain the increase, you will lose sales. Increasing sales volume may be a better way to improve a business’s gross profit without increasing cost of goods sold or changing your selling price. Increasing sales volume can in fact reduce the cost of goods sold since the fixed cost per unit becomes smaller as production volumes become larger. An increase in sales that is accompanied by a reduction in cost of goods sold per unit, results in a higher gross profit.
The alternative approach to price rises or increasing sales volume is to reduce your cost of goods sold. Cost of goods sold are the direct costs attributable to the production of the goods sold by your business. This includes the cost of the materials along with the labour costs directly linked to creating the products or services that your business sells. All other expenses that are not a direct cost of delivering the product or service are allocated to operating expenses and will affect the net profit rather than gross profit. This is the second level, or bottom line profit, that will appear on a profit and loss statement. While reducing cost of goods sold is more difficult without compromising your quality, there are usually ways such as finding lower-priced suppliers, cheaper raw materials, requesting supplier volume discounts, using labour-saving software and technology or outsourcing. The bigger the difference between cost of goods sold and sales, the bigger the gross profit margin will be.
Now that you know what needs to be done to improve gross profit you need to be able to measure it to compare figures and understand the changes over different reporting periods. Gross profit can be calculated by using a ‘gross-profit-margin ratio’. This figure is arrived at by deducting the cost of goods sold from your net sales, which is your gross profit, and then dividing this figure by net sales. The result is a percentage of the sales that goes towards the gross profit. So there you have it, increasing revenue and or a reduction in cost of goods sold improves gross profit and results in an increase in your gross profit margin and your chances of maximising the overall profitability of your business.