What is Gross Profit and Why Does it Matter?

Gross Profit is one of the most important metrics you should track and understand in your business, because it’s a key indicator of your company’s health and longevity. Despite that, most small business owners don’t know what constitutes Gross Profit or don’t know how or why they should track it.

In this post, we’ll discuss what Gross Profit is, why it’s important, and how to track it.

What is Gross Profit?

First, let’s provide a definition for Gross Profit. Gross Profit is the amount of money your company makes after deducting the costs directly associated with making or selling your product or service. Said another way, Gross Profit represents the leftover money from your Revenues once you’ve backed out the costs you incurred to earn that Revenue.

The Accounting formula for Gross Profit is Revenue less Cost of Goods Sold (COGS), where:

Revenue = the amount of money you earned by selling your product or providing your service, and
Cost of Goods Sold (or Cost of Revenue) = all the direct costs associated with producing and selling a product or service (such as inventory, direct labor costs, and allocations of certain types of overhead).

Oftentimes, Gross Profit is expressed as a percentage of total revenue, and is known as Gross Margin. For example, if a business has total Revenue of $100,000 and COGS of $60,000, the Gross Profit would be $40,000 and the Gross Margin would be 40%.

Revenue is generally understood and known by business owners. In most cases, Revenue is equal to net sales, though in some cases the timing of when you recognize your Revenue will differ and depend on when you actually earned it (a concept that can be complex and may require assistance from an Accountant who understands Generally Accepted Accounting Principles (GAAP)). For most small businesses, though, net sales and Revenue are one in the same and are recognized in the same period.

Cost of Goods Sold is more complicated, as it’s important to distinguish your COGS from your Operating Expenses. Not every expense you incur in your business is COGS (nor is every expense you incur an Operating Expense). That distinction is critical, but it varies in every business and often requires subjective judgment.

That being said, the key difference between COGS and Operating Expenses is that COGS represent the costs directly related to your revenue-generating activities, while Operating Expenses represent the indirect costs you incur to support and run your business.

If your company sells goods, then your COGS will include all the costs associated with purchasing or making those goods (both product and labor); if your company provides services, then your COGS will include all of the costs of labor (whether compensation for full-time employees or costs for subcontractors) directly related to your provision of services. On the other hand, your Operating Expenses will typically include compensation costs for employees not directly producing products or providing services, software fees, marketing and advertising fees, insurance fees, legal fees, accounting fees, etc.

One of the most common mistakes small businesses make when tracking Gross Profit (if they track it at all) is the incorrect allocation of expenses between COGS and Operating Expenses. Unfortunately, this mistake can prove detrimental to good decision-making, as it will demonstrate Gross Margins that are higher or lower than reality, a topic we’ll cover in more detail in the next section. This is why it’s important to understand what Gross Profit is and ensure all of your expenses are categorized correctly (this is also why it’s critical to hire a good accountant or bookkeeper to keep your books).

Why is Gross Profit Important?

So, why is Gross Profit important? Gross Profit is important (read: critical) because it:

A. Provides a barometer for your business model itself. As a business owner, it’s imperative you determine whether or not the product you sell or the service you provide is actually capable of generating a profit.

Are customers willing to pay a price, not just in excess of the costs you’ll incur to produce/provide your product/service, but with enough excess to also cover your Operating Expenses at scale and generate both Net Income and free cash flow? You can only make that determination by tracking and assessing your Gross Profit and Gross Margin.

B. Is the foundation for strategic decisions to grow and scale your business. Low Gross Margins are not always bad. Some companies knowingly accept a lower Gross Margin, because they can sell their product/service at a high enough volume for the Gross Profit to cover their Operating Expenses and still yield Net Income.

For many businesses, though, that is not the case, and it’s imperative they’re able to generate a higher Gross Profit. Should they increase their prices? Should they find ways to decrease cost (if that’s even feasible)? These are just some of the basic questions business owners need to answer, and the starting point is based on their current and historic Gross Profit.

This isn’t even to mention a more advanced and deeper dive into Gross Profit by customer, project, product, location, etc. The main point we’re trying to make here is that the better you track and the more you know about your Gross Profit, the better-equipped you’ll be to make critical business decisions to grow and scale your business.

How to Track Gross Profit

Tracking your Gross Profit is one of those things that’s easier said than done, and like most, the devil is in the details. Simply put, you need adequate systems and processes to appropriately track your Revenue and COGS (not to mention your Operating Expenses and all of your other financial transactions/data).

For most small businesses, there’s a myriad of Accounting systems available for little to no cost, but the most popular today are QuickBooks and Xero (at Margin CFO and Bookkeeping, we prefer QuickBooks for a number of reasons, but the most important thing is that you select one that fits and can scale with your business).

At a minimum, you should track your Gross Profit in whole. As noted above, though, where you’ll gain the most insight to drive critical business decisions is by tracking your Gross Profit in a more granular fashion. There are numerous ways to do this, all of which depend on your business, industry, etc., but the most common are as follows:

  • Gross Profit by Customer
  • Gross Profit by Location
  • Gross Profit by Product
  • Gross Profit by Category

To relay a point made earlier, the most important step is to first determine what actually constitutes your COGS. Once you’ve made that determination, you can then think through the actual mechanism for how you’ll track it.

For example, if you want to know your Gross Profit by Customer, then you need to think about all the processes and systems involved on both the Revenue and COGS side of things, and what would be required for identifying and/or attributing specific Revenue and COGS to specific customers. This will likely prove the most challenging part, as it’s not always straightforward to allocate financial transactions to specific customers, locations, products, etc. Revenue can be easier (in some cases), but COGS can be difficult and requires that you think through your business operations and align on a methodology for capturing and allocating costs according to how you want to track Gross Profit.

The good news is that once you’ve figured that part out, systems like QuickBooks are more than capable of doing the actual tracking, provided you know how to configure it (or get help from experts like us).

In addition to assessing your Gross Profit by customer, location, etc., it’s also important to track and analyze your Gross Profit over time to see if there are any trends or patterns. For example, if Gross Profit is decreasing over time, it may indicate that the business needs to review its pricing strategy or production costs. On the other hand, if Gross Profit is increasing over time, it may indicate that the business is doing well and that the current strategies are working.

It’s also a good idea to know and compare your company’s Gross Margins to industry averages to see how they stack up against other businesses in your industry. This can provide valuable insights into how competitive your business is within its industry.

In conclusion, Gross Profit is a critical financial metric to track and understand. By tracking and analyzing Gross Profit and Gross Margin over time, and comparing it to industry averages, business owners can gain valuable insights into their financial performance and make informed decisions to grow and scale their business.

As a Bookkeeping and CFO services provider, we help business owners track their Gross Profit and other financial metrics, provide financial analysis and make recommendations for improving financial performance. Contact us today to learn how we can help your business.