How To Use Gross Profit Formula To Improve Sales (with Definitions and Examples)
By Indeed Editorial Team
Updated March 16, 2021 | Published February 4, 2020
Updated March 16, 2021
Published February 4, 2020
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Gross profit is a measure of how efficient a company's business operations are. It's an important metric that companies should track continuously to make informed business decisions about when and how to cut costs or invest more into increasing revenue.
In this article, we will discuss what gross profit is, why it's an important metric for businesses to track and how your small business can best use the gross profit formula.
What is gross profit?
Gross profit refers to the profit made by a company after any operating costs have been deducted. To calculate gross profit, take the total sales revenue earned in the time period and subtract all sales costs in that same time period.
It is important to note that this does not include either operating expenses or non-operating revenues. Gross profit is only intended to measure how much a company earned from its normal business operations such as the sale of products and services and how much it spent to provide those products and services.
Other operating costs like paying rent on office space, paying for a marketing campaign or running a human resources department might be necessary to run a business but they aren't directly related to sales. Likewise, other sources of revenue like interest earned on an investment or income earned from selling off company property might add to the company's assets but they are not directly related to its sales operations.
While these other sources of revenue and costs are certainly important, including them in the calculation of gross profit can obscure the data. It can be challenging to understand the relationship between how much a company spends on, say, hiring new employees for the sales team and how much additional revenue has resulted from the resulting increase in sales if the data also includes revenue or costs from all these other sources.
The reason a company tracks gross profit is to monitor how efficiently it uses its labor and supplies to produce the products or services that drive its income. The main way to determine this is to compare it to sales revenue, which is simply the total amount of income earned from sales before subtracting the cost of sales.
Why is gross profit important?
Gross profit tells a company how efficient its operations are. A large difference between gross profit and sales revenue suggests that there is a problem that needs to be addressed urgently. This is especially true if the gross profit is negative, which means the company is spending more on labor and supplies than it is earning in sales revenue.
The specific issues that cause a low gross profit can vary. Some of the most common causes include:
The cost of supplies has gone up
The price the company is selling their good or service for has gone down
Changes to a company's operations, such as expanding their service area or working with a new supplier, that cause costs to go up
New or intensifying competition from other businesses in the industry
Changes to the industry render the company's current goods or services to become dated, resulting in decreased sales or the need to invest in expensive changes to bring its product up to date
The company is new so the customer base is not yet large enough to cover the cost of labor and supplies
Determining what specifically is causing your company's decline in gross profit will require bringing in more data to get a complete picture of what is happening. The main role of gross profit is to alert a company that it's time to do a deeper analysis and that the problem lies either in the revenue stream or in the costs of sales.
How to use the gross profit formula
The formula to calculate gross profit is simple. It's sales revenue minus the cost of sales. The steps below will help you calculate an accurate gross profit for your business:
Calculate sales revenue. This refers to all revenue earned directly from sales. So, revenue streams like product orders, services or subscription payments would go into this amount.
Calculate cost of sales. This value should include things like cost of labor, supplies, storefronts, shipping costs and so on. These are all directly tied to your company's sales.
Subtract the cost of sales from the sales revenue. The remaining revenue after subtracting cost of sales is the gross profit.
Once you have calculated the gross profit, it's time to interpret it and find out what it means for the company going forward. In the next section, we'll talk about how to correctly interpret the change in gross profit.
How to interpret the results of the gross profit formula
Interpreting what the gross profit formula means for your business will take a little more investigation and analysis beyond just calculating what it is. Here are some important steps to follow as you figure out what the gross profit says about the company's financial health:
1. Examine the sales revenue
For the same time period that you calculated the gross profit, take a closer look at sales revenue. Identify any changes in this account compared to the previous time period. This might include things like a change in the number of sales, a change in the price of goods or services, a change in the average revenue per sale or a change in which goods or services are the strongest sellers. Take note of each change that occurred to sales revenue and the cash value of that change.
2. Examine the cost of sales
Do the same close examination you did for sales revenue for the cost of sales account. Here, you might see things like a change in the price of supplies, a change in the size of the sales team or the average salary per sales employee, a change in the manufacturing process or a change in the number of goods produced.
3. Compare revenue changes with cost changes
For each change you have noted in costs, try to correlate it with a change in revenue. Take note of any increase in the cost of sales account that is not at least balanced out by an increase in the revenue account. Then, take note of any decreases in revenue and look for correlations in costs.
4. Draw conclusions
Based on the changes that have occurred in each of these accounts and the relationship between those changes, you will start to see a picture of what is happening with the company's sales. From here, you will be able to determine whether the company is spending money inefficiently or whether it has the labor and supplies it needs but it is not deploying them as efficiently as it should be.
A mistake that some companies make is seeing a gross profit they aren't pleased with and immediately concluding that the solution is cutting costs. It's important to remember, however, that cutting costs also cuts capacity. In the long term, seeking solutions that increase revenue is always better for a company's financial health than seeking solutions to cut costs. This is because increasing revenue actually produces growth, whereas cutting costs simply slows down the rate of decline.
3 examples of the gross profit formula
Calculating your gross profit for a given time period will yield three potential scenarios. In this section, we will take a look at what kind of decisions a company might make in each of these three scenarios.
Gross profit increases
If gross profit has increased, this is a good sign. However, it still needs to be analyzed. As a decision-maker, you should look for the source of that increase. In the best-case scenario, the growth is in the company's revenue, but it might also be the result of a cut in costs.
Once you have found the specific source of the increase, you can determine how to move forward. If it was revenue growth, a company might identify what led to that growth and invest more in that in hopes of seeing even more growth in the next quarter. If the growth is the result of a cut to costs, a company might consider whether this is a cut that is sustainable over the long term or whether it's a cost that it will need to bring back to see growth in the future.
Gross profit decreases
When gross profit decreases, this could indicate one of four trends:
Costs have gone up but revenue has stayed the same
Revenue has gone down but costs have stayed the same
Both costs and revenue have gone up, but costs are increasing at a faster pace than revenue
Both costs and revenue have gone down, but revenue is decreasing at a faster pace than costs
The trend a company is experiencing will influence the best course of action going forward. If costs are going up but revenue is not, this is a sign that the company is not spending money efficiently. If revenue is going down but costs are staying the same, this might be a sign that there is a change in the industry or market demand. In this case, a company might consider redesigning its goods or developing new products which might increase costs in the short term but will help recover its revenue in the long term.
If both costs and revenue have gone up but costs are growing faster, this could mean the company is on the right track but might be able to achieve this same revenue growth at a lower cost. Alternatively, it could mean that the company has invested in developing new products, leading to temporary inflation of costs. If that's the case, it would be better to make no change and wait for costs to stabilize again.
If both costs and revenue are going down, this could be a sign that the company has cut costs in the wrong place. Fixing this might actually require adding new costs to recover the lost revenue stream.
Gross profit is negative
A negative gross profit means that the company is spending more on sales than it is earning in sales revenue. This is a cause for alarm, but it does not necessarily mean the company is failing. There are several reasons this could happen, some normal and some problematic.
A normal cause of negative gross profit includes being a startup that is not yet turning a profit. For these newer companies, the important thing is to look for a trend toward a smaller negative value. The high cost of starting up will pay off in the long run but if costs continue to go up while revenue continues to stagnate, it could mean something is wrong.
Another normal cause of negative gross profit is similar to the scenario mentioned above. The company is investing in research and development to respond to a change in the industry or market demand. If the cost of development temporarily becomes higher than the revenue, it's not an immediate cause for alarm. However, if it doesn't stabilize soon, it is a cause for concern.
If there is no clear cause, this might mean that competition in your industry has intensified and your company is not doing what it needs to remain competitive. It might also mean that something in your sales process is no longer working. The steps provided above for interpreting the gross profit formula will help you identify what's causing this negative gross profit and develop solutions for restoring it.
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