Do you track and analyze your business finances? If so, that's great. That means you're building healthy money management habits. Unfortunately, not all metrics help you gauge the efficacy of your efforts. Two pieces of data you must record to determine the financial stability of your business are gross profit and gross profit margin (also known as gross margin).
These two terms sound extremely similar, but they're actually very different and should be treated as such. Let's compare gross margin vs. gross profit. What are these metrics, how are they calculated, and why do they matter?
What is Gross Profit?
To understand gross profit, a definition is helpful. This term describes a company's total sales minus the cost of revenue generation. In other words, it is your revenue minus other expenses. Gross profit is always measured in dollars, and it measures how well you generate profit from labor and materials.
To calculate the metric, use this formula:
Gross Profit Formula: Net Sales - Cost of Goods Sold (COGS) = Gross Profit in Dollars
- Net Sales: This part of the equation refers to the total amount of money earned from sales during the time frame you want to measure.
- COGS: This part of the equation refers to the direct cost of producing your product. This includes:
- Direct labor costs
- Direct material cost
- Equipment costs
It's important to note that generally accepted accounting principles demand profit and loss (P&L) statements have gross profit clearly labeled. If you want to learn more about profit and loss statements and how to write them, check out our complete guide to the process.
Gross Profit Example
Let's use an example to calculate gross profit and see how the formula works. Consider a theoretical flower shop. If we say it generated $1,000,000 in sales for 2020 and its CGOS was $300,000, and we plug that into the equation, it looks like this:
According to the formula, this flower shop's gross profit in 2020 was $450,000.
What is Gross Profit Margin?
Gross profit margin, or gross margin, is always measured as a percentage. It represents the percentage of sales that exceeds your cost of goods sold. This metric shows how well you generate revenue from the costs required to produce your goods. The higher the margin is, the better your company is at generating revenue for each dollar spent on CGOS.
To calculate gross margin, use this formula:
Gross Margin Formula: (Gross Profit/Net Sales) x 100 = Gross Margin Percent
- Gross Profit: This refers to the metric we calculated previously. Sales minus cost of goods sold.
- Net Sales: This refers to the same thing as the gross profit formula, total money earned.
Gross Profit Margin Example
Examples are the best way to make sure you understand something, so we'll do another quick calculation to reaffirm the gross margin concept. We've already established that the theoretical flower shop's total sales were $1,000,000 in 2020 and calculated that its gross profit was $450,000. If we plug these figures into the formula, we get:
($450,000/$1,000,000) x 100 = 45%
In 2020, the flower shop's gross profit margin was 45%. How does this stack up to gross profit margin standards?
- Low Gross Profit Margin: Anything less than 5%
- Average Gross Profit Margin: Anything around 10%
- High Gross Profit Margin: Anything above 20%
Based on these factors, you can see that the theoretical flower shop knocked it out of the park last year.
To further drive home the concept of profit margin, imagine that the theoretical flower shop has a competitor on the other side of town. They both have the same gross profit, but while the theoretical flower shop has a gross margin of 45%, the competition only has a margin of 30%. Does this mean that the theoretical flower shop is a better business than its competitor in every way? Not necessarily.
What it does mean is that the theoretical flower shop is more efficient with its inventory. It could also mean that the shop pays their employees a couple more dollars per hour or has other higher overhead costs than its competitor.
Why These Are Important Metrics to Track
Recording gross profit and gross margin are essential if you want to track your business operations' overall health. The importance of both metrics cannot be overstated. If you were to measure gross profit alone, you would be able to assess your profits and find the gaping holes in your business model. When you add in the gross profit margin, you get a better feel for how good your business is at generating revenue from what you already have. Being efficient with inventory is crucial to success. If your competitors also measure their gross profit margins, you can use this percentage to see how you stack up against each other.
Gross profit and gross profit margins are similar to profit and profitability. You've got to measure both if you want a fuller picture of your business and its ability to generate revenue efficiently.
Does Your Business Need Access to Capital?
If you don't measure gross profits, you have to start. This will be a game-changer for your business model and help you understand the bigger picture. If you also start measuring your gross margins, you'll understand how efficiently your business uses inventory. By measuring these two factors, you will see how your business practices fit into the bigger picture. You'll see places for improvement and develop more effective growth strategies.
Did you know that gross profit and gross margin are key factors used by banks and lenders to determine your business's ability to repay a loan, line of credit, or cash advance? If you need access to capital because you haven't been tracking the right metrics and your business is struggling, you have options. There are a number of ways to finance your business, but if you need access to capital immediately, call the finance experts at AdvancePoint Capital, and you can get funds within a day.