If you have an online business or are planning to set up an online store, you will want to be familiar with basic business accounting terms like “gross profit”.
Gross Profit Definition
What is gross profit exactly?
A company’s gross profit is the resulting figure when you deduct the totalcost of goods from your total sales. Total cost of goods is the direct cost of producing goods. Cost of goods is also referred to as COGS. [1]
Total sales, on the other hand, means the total revenue of all the goods that were sold by your business at a particular time.
Definitions of gross profit across many sources generally describe this simple formula.
Gross Profit Calculator for your Online Store
Gross profit = total sales of your online store - total COGs (cost of goods)
However, relying solely on this figure gives you no points of comparison for different sales periods. You will also have a poor idea of how the store is doing as COGS may fluctuate on a daily or periodic basis.
This is a basic measurement but it should not be used as a tool to assess how well your business is performing. When you compute gross profit, you only look at what you make versus your direct costs. Your indirect costs are not factored in. This includes marketing and distribution costs. When you neglect such factors, you might mistakenly believe that your business is doing well, when in fact it is bleeding from other cost areas.
To get a better picture, you will then need to learn how to compute for gross profit margin, net profit and net profit margin.
Let’s Move on to Gross Profit Margin
Why is knowledge of gross profit margin useful? Do online entrepreneurs need it?
To evaluate your company’s financial state, you will also need to be able to compute the gross profit margin, expressed as a percentage, to determine how well your business is doing.
Entrepreneurs and small businesses need to understand the concept of gross profit margin because it is an important metric in assessing a company’s financial health.
The inability to comprehend or calculate gross profit margin, and use it periodically to assess the financial health of your company could put you in jeopardy. Understanding the gross profit margin or gross margin ratio will help you understand your sales performance vis a vis the cost of producing or acquiring the goods that are for sale on your online store.
Gross profit margin, unlike gross profit, is expressed as a percentage.
Gross Profit Margin Formula
Gross profit margin is computed from the company's net sales minus the cost of goods sold (COGS).
Net sales consider broader costs like general and administrative costs and sales costs.
The gross profit margin formula is as follows:
Gross profit margin = (Net Sales - COGS) / Net sales
Note that your company’s gross profit margin calculation entails subtraction of the COGS from the net sales. Net sales equals gross revenues after the deduction of the cost of returns, discounts and allowances. The net sales is also the denominator in this formula, in order to express the gross profit margin figure as a percentage. [1]
What can this figure tell you?
Gross profit margin can give you some idea of how steady and stable your business is. It can, to a degree, detect inefficiencies and issues with your business model, or spot quality issues in your product. It simply reflects what you make from the production of your goods from a percentage point of view. Unlike gross profit, the percentage margin is useful as you can apply it reasonably to any gross sales figure and have an idea of how much you are earning.
It gives you a better picture of how your business is doing overall, because it considers your net sales. It does not tell you everything about your business operations, because it does not include other operating costs.
How to Use Gross Profit Margin Correctly
What to watch for:
- Fluctuation. When this figure fluctuates, it may indicate that your management practices are poor. It may also indicate substandard products, judging from, say, a high number of returns or dropping sales. When is fluctuation acceptable? When you are trying to implement changes in your operations or big changes to your business, this may often manifest as fluctuation in gross profit margins. Expect this temporary change and do not worry about it, if it is indeed a result of a sweeping operations decision.
- Mid- to long-term trends. In continuation to the above, you need to monitor your business for volatility in the short, medium and long-term. You have to compare it with your plans for your company. If your strategy involves automation to save costs in the long term, this may reflect as an initial drop in your gross profit. Yet, as a result of your investment in operations and other costs as reflected in your net profit figures, your COGS will eventually decline. This will be a result of lesser expenses in terms of labor (i.e., in manufacturing).
- Effects of pricing. One of the variables in this figure is of course the price of your product as it goes to market. If you decide to position your products on the high end of the price spectrum, say, as a luxury good, you will have a higher gross profit margin. Premium pricing results in increased gross margins in general. However, this advantage could backfire in other ways. Sales volume could be affected. It could cause consumers to switch to more affordable products, which could cost you some of your share in the market. You just need to be clear about your pricing strategy from the start and know that it could heavily affect your margins, as already explained.
- How you react to competition. Gross profit margin could also be used to see how you fare versus your competitors. They might have a better business model with lesser manufacturing costs, as a result of a patented discovery or innovation, for example, which may cut their product cost or COGS, thereby giving them better margins. However, to counteract this, one may decide to change the price lever, and increase margins in another way. Such balancing of strategies are crucial for learning how to adapt and survive in the market.
What is the difference between net profit margin and gross profit margin?
While gross profit margin is the resultant percentage of dividing the gross profit by the total revenue, and is expressed as a percentage of income that is left after consideration of the cost of goods, net profit margin casts a wider net: apart from COGS, it includes other costs involved that are indirectly related to selling the product. Examples of these costs are: payroll, rent, freight, utilities payments and other forms of overhead. It includes cash flow items, taxes, debt servicing and others that are not considered in gross operating profit margin.
Taxes are included in net profit margin computation.
Net profit margin gives you an even clearer picture of your operations. It gives you an idea of all your outgoing payments, other income, debt servicing costs including interest, revenue from your secondary operations and costs from single incidents such as taxes or lawsuits.
What Net Profit Margin is Used For
Companies use net profit margin to have a more concrete picture of how well a company is doing. The changes in net profit margin indicate how well your company is operating and whether your business practices are sound. It is also a basis for future projections.
As a percentage figure, you can compare businesses of varying sizes in terms of profitability. It is also a tool for investors for evaluating management effectiveness and the efficiency of the company’s operations. Increasing net profit margins year-on-year are a positive indicator.
Net profit margin correlates with share price because it correlates with a company’s earnings. It is standard reporting for publicly traded companies or any large corporation that publishes annual reports to its shareholders.
How useful are these terms to a small online business?
If you are planning on setting up an online store, you will want to look up full-functionality website builders such as Strikingly. The Strikingly platform lets you set up a free e-commerce business site without the fuss. It can offer you the best free start when creating that online business you’ve always been dreaming of.
Strikingly’s designs and functionalities enable you to plan and construct your e-commerce business from start to finish. To manage your store, you will need some basic literacy, though, and that’s how knowledge of gross profit comes in.
If you’ve read this far, you already have an idea of what gross profit, gross profit margin and net profit margin are. Gross profit is immediately useful--you need to start computing it as soon as you start your business. Understanding gross profit allows you a basic understanding of one thing: on whether you stand to make money or not based on the cost of your goods. It can help you evaluate whether you are pricing your products correctly.
However, it is not a solid figure to base any business decisions on. You need to move on to the gross profit margin formula in order to expand your understanding of your business dynamics. This time, apart from knowing your gross profit, which you derive from your total sales figures minus your cost of goods, you can assess if you really are still profitable if you add in your discounting strategies, issues like returns and other indirect costs associated with your goods. Once you have that, then your knowledge of your business expands and you may realize a few things that you missed before.
Drastic changes in your gross profit margins indicate something may be wrong. If you are not trying to change your business model or automate your manufacturing, you might want to dig deep into the quality of your product, your pricing strategy and other costs associated with the production of your items.
Expanding further, net profit margin is really more solid ground from which you can base larger decisions and evaluate the overall health of your business. If you have this figure with you, then it means you have accounted for the many other costs associated with your operations, including your cash flow and overhead. It can indicate the effectiveness of your management and the robustness of your operations. It can even give you an idea on whether your business is profitable and can survive in the long-term.
Knowledge of all three can help you in many ways as you scale your online business. If you are feeling overwhelmed, start with the basic gross profit equation. You can take on the other figures once you get the hang of it. Just remember that as you scale your e-commerce operation, all of these formulas will come in handy.
