It’s the year – you just know it. You finally gave that side gig you’ve been dreaming about a real shot and it’s starting to pay off in more ways than you think. What started out as just a hobby for baking quickly turned into opening his own brick-and-mortar bakery on the corner. Now, you’re wondering if it’s time to take the next step and prepare your side for your full-time job, but you want to make sure it’s the right financial decision.
In this post, we’ll teach you how to measure your company’s efficiency and profitability using the gross profit formula, to help you understand if you’re making the right decisions. By subtracting cost of goods sold (COGS) from your revenue, you can find gross profit, and make data-driven decisions about where to invest and where to save.
Calculating profit margin allows you to clearly see whether your side job is ready to turn into a full-time business.
how to calculate gross profit
Gross profit, also known as gross income, uses variable costs to measure efficiency. It is the profit left over after deducting the costs associated with providing the service or manufacturing and selling the product. These variable costs, such as shipping and raw materials, change based on production level, as opposed to fixed costs that remain constant each month such as salaries, rent and marketing costs.
The higher your gross profit, the more efficient your company is at using supplies and labor to produce goods or services. Gross profit is a dollar amount that you can calculate using the following formula:
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Revenue is the total amount that your company brings in from the sale of products or services during a specific period. This is your total income before any deductions and can be found on the top line of your income statement.
Cost of Goods Sold (COGS)
Cost of goods sold is the manufacturing cost associated with producing and delivering your products or services. These are variable costs that do not take into account any fixed costs.
Examples of COGS:
- production equipment cost
- shipping cost
- production utilities
- raw material
- production labor cost
Example of Using the Gross Profit Formula
Now let’s see how to calculate your bakery’s gross profit for the year.
First, you’ll need to calculate total revenue — the total amount your customers paid for your baked goods during the past year. Looking at your annual income statement, you see that your total sales were $375,000.
Next, you’ll calculate your COGS by looking at how much you spent on labor, materials, and packaging throughout the year. Looking at your income statement, you determine that your COGS is $285,000.
Using the gross profit formula, subtracting $285,000 (COGS) from $375,000 (revenue), you end up with a gross profit for your bakery of $90,000 for the year. You’ll notice that we haven’t taken into account any fixed expenses – these will come later when we calculate net profit.
How to Calculate Gross Profit Margin
Gross profit margin, also known as gross margin, uses a gross profit calculation divided by total revenue, then multiplied by 100 to determine the profitability percentage of your manufacturing and production processes. You can calculate gross profit margin by using the following formula:
Gross Profit Margin = [Gross Profit / Revenue] x100
Gross profit margin is a way of showing your gross profit in a ratio or percentage rather than a dollar amount. You can calculate this monthly or annually using your income statement, but to get a real sense of your company’s performance, you’ll want to compare your profit margin with previous months or years. This will allow you to see whether margins are increasing or decreasing and will inform your decisions when making adjustments as needed.
Example of Using the Gross Profit Margin Formula
Let’s use the same income statement we used earlier to calculate gross profit margin. Subtracting $285,000 (COGS) from $375,000 (revenue), you found your gross profit was $90,000.
Now, we take that $90,000 and divide it by the total revenue of $375,000. This gives you 0.24 which you would multiply by 100. This equals 24 percent, which means your bakery had a gross profit margin of 24 percent for the year.
Gross Profit Vs. Net Profit
The key to understanding how your company is doing financially is knowing your gross profit and net profit, also known as gross income and net income. Gross profit measures the productivity of the manufacturing and production processes, while net profit measures the productivity of the company as a whole. To find the net profit, you would use the following formula:
Net Profit = Revenue – Total Cost
Total Cost = Cost of Goods Sold + Taxes + Overhead Expenses
This is where those other fixed expenses would come in, so let’s look at that income statement again to calculate your net profit for the year.
Looking at your income statement, you can see that your COGS is $285,000 and your total expenses are $80,000. Let’s add them up, bringing your total cost to $365,000. Now, you would subtract $365,000 (total cost) from $375,000 (revenue), giving you a net profit of $10,000 for the year.
how to calculate net profit margin
Net profit margin, like gross profit margin, is a way of showing net profit in a ratio or percentage. It can be calculated using the following formula:
Net Profit Margin = [Net Profit / Revenue] x100
Given the same income statement, you can calculate the net profit margin by taking your net profit of $10,000 and dividing it by your total revenue of $375,000. This gives you 0.02, which you would then multiply by 100 to equal 2.7 percent. This means your bakery had a net profit margin of 2.7 percent for the year.
average profit margin
So, now that you’ve calculated your gross profit margin and net profit margin, how do you know if it’s a good fit? Looking at the average profit margin for your industry can help you determine whether you are on the right track or need to make adjustments.
If you compare your bakery’s gross profit margin of 24 percent and a net profit margin of 2.7 percent with the retail (grocery and food) industry businesses with average profit margins of 25 percent and 1.1 percent, respectively, you’ll see that your The profitability levels are where they should be.
How to improve profit margin and grow your business
Knowing your gross profit margin and net profit margin allows you to make important financial decisions for your company based on the data. If you compare your gross profit margin to the industry average and find that it should be less than that, here are some things you can do.
- Increase Productivity: Consider how you can serve more customers in less time by making small changes to your process that increase efficiency. These can be things like making a batch of frosting that can be used for a variety of cupcakes, rearranging your assembly line to save time, or preparing dry ingredients for recipes ahead of time.
- Subtract COGS: Cut labor costs by training your employees on multiple skills instead of hiring additional people, buy in bulk, or find an inexpensive way to source your materials to find less expensive shipping options.
- Raise prices: To offset costs, especially when the economy is unstable, you can raise the prices of your products. Make sure you are careful not to raise prices too high, which could lead to a drop in sales.
Assessing your company’s utilization and profitability helps you make sound decisions and see if your side is ready to turn into a full-time business.
Creating a business budget is a great way to plan for expenses and track your cash flow, so you’re not surprised by your profit margin at the end of the year. Download our free Mint app to track your business goals, budget, and see where your money is going, so you can move one step closer to financial freedom.
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