Gross profit is an important area of a company’s income statement that can provide crucial insights on how effectively you are using your resources to make and sell your products or services. “Gross profit is important as it indicates whether your pricing and purchasing strategies facilitate a return and make the business viable,” says Nila Khan, Business Advice Manager at the ICAEW.
Here’s a look at what gross profit is and how you can use it for growth.
Gross profit definition
The gross profit margin measures the money left from the sale of your goods or services, once the direct expenses used to generate them are deducted (e.g. labour and material costs). It varies across products and sectors, and is often used to measure the profitability of a single product.
What is the difference between gross profit and net profit?
Gross profit focuses on the value of your sales, minus the costs directly involved in making the sale. In contrast, net profit defines a final level of earnings, says Khan. It takes into account all business overheads such as salaries, rent and administrative expenses. This means net profit is a lower number than gross profit. You’ll often see gross profit and net profit converted into a percentage and described as a margin, e.g. 'net profit margin'.
Example of gross profit
Imagine you sell your products for £10 and that item cost you £4 to make. Gross profit deducts the direct costs in making your product, known as cost of goods sold (COGS) from the sale price, or total revenues. In this example, your gross profit would therefore be £10 minus £4 = £6.
Example of net profit
Net profit takes the total gross profit and deducts all your other business expenses from it, such as office rental and utility bills. Taking the example above, imagine your total gross profit was £6000-per-month and your monthly overheads are £1000. Your net profit would be £6000 minus £1000 = £5000.
Why is gross profit important?
Careful management of gross profit can ensure that the healthiest possible net profit is achieved, says Carl Reader, Chairman of d&t Chartered Accountants. A high gross profit margin generally indicates you’re making money on a product, whereas a low margin means your sale price is not much higher than the cost. Several factors can impact gross profit, such as exchange rates, delivery costs and even the mix of products and services offered, says Reader.
Gross profit can support small business owners in understanding what price to charge customers, says Khan. It can show you if the purchase price of goods or services directly linked to sales is low enough to generate a profit. If not, you can take measures to improve it, such as by driving greater efficiencies in production, negotiating lower prices with your suppliers or by revising the price you charge customers. Gross profit can also be used to look at year-on-year performance of specific product sales, which can help you identify trends and patterns that can inform future sales, she says.
Christine Nicholson, a business mentor, sums up the value of gross profit. “Without knowing it, you have no idea what your breakeven is or how much you need to sell to keep afloat.”
Limitations of using gross profit
A strong understanding of gross profit allows you to make quick decisions to support the growth and resilience of your business. But it doesn’t take all your overheads into account. “If a business ran solely through the management of gross profit, it might find itself in a situation where overheads escalate out of control and whilst the gross profit might look healthy the business might be running at a loss when the end result is calculated,” says Reader.
How to find your gross profit
The gross profit figure can be calculated by subtracting the costs involved in making your goods, known as the total costs of goods sold (COGS), from the revenue. Specifically, Gross Profit = Revenue - Cost of Goods Sold. COGS includes the total expenses used directly in producing your products or services, such as raw materials and labour. It doesn’t include wider business operating expenses such as rent, utilities and other employees' wages.
You can learn more on how to find your gross profit in our article “How to Calculate Gross Profit”.
How to manage your gross profit margin
Monitor your profit margins regularly
Monitoring is key, says Nicholson. Claude Compton, founder of Pave Projects, undertakes a weekly review of his company’s profit margins. “We look at gross margins and specific KPIs in real-time daily and review in more detail weekly,” he says. "In 2020, it allowed us to steer the business through by isolating cost-cutting and revenue-driving areas, necessary to avoiding losses in a very challenging year for hospitality." For example, Pave could quickly spot recession related price increases and implement technology to increase the speed of service and boost total sales revenue.
Use profit margins as a tool
Profit margins are a retailing tool. "You can flex your gross margin to sell old stock, increase footfall and increase loyalty," says Andrew Goodacre, CEO of the British Independent Retailers Association. For example, some retailers deliberately create "loss leading" products by keeping margins low, with the expectation of selling customers other more profitable items, he says.
Build them into your business model
A common reason for low profit margins is the business model, says Goodacre. But this isn't always a negative. Low-cost retailers such as Lidl and Aldi deliberately run low margins but with low overheads. Conversely, Waitrose operates higher margins in return for a higher perceived quality.
Keep a long-term record
By regularly tracking your margins, you're growing a valuable pool of data that you can use to analyse performance over time and across markets. This can help you to understand the customer market that your business is attracting, says Goodacre. For example, by enabling you to spot whether a product is more profitable in one market over another or at certain times of the year.
Nicholson suggests that regularly reviewing customer demand can help you understand whether there is customer appetite for price increases to improve gross margins rather than driving down prices to increase competitiveness. “Most business-to-business customers will expect price rises and stay with you if you have a good relationship and they are getting great value,” she says.
Understanding your margins helps you to better manage your cash flow, ensuring there's always enough money to pay your suppliers and expenses on time. The American Express® Business Card has a 54 day payment period, giving you more control over your cash flow and when you make your payments¹. Find out more here.
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