There is no other line on your Income Statement that has so many business processes feeding into it. Gross Profit is a financial barometer for your business. Understanding Gross Profit could gain competitive advantage and more money for your business.
So what is Gross Profit and how do you calculate it?
In simple terms, it is Sales minus Cost of Sales.
Now let’s break these two concepts down:
Sales = Selling price per unit x Total number of units sold
Cost of Sales = Materials costs + Labour costs + Manufacturing costs + Distribution & selling costs
Therefore, gross profit is the amount of money left over after paying all costs directly associated with getting your product to market.
It could be argued that every single cost you incur is related to bringing your product to market. Whilst this is true, it is desirable to split up your costs into two (2) categories:
- Costs that can be directly attributed to the products and services that you sell
- Overhead costs that not directly attributable to any particular product or service but are more related to being in business, regardless of whether you make a sale or not. (e.g. office rent, administration costs)
Why is it desirable? This seemingly arbitrary splitting of costs becomes important when you have more than one product and / or service. For example, attributing costs to product A and product B enables you to work out which product is more profitable.
Another way of looking at gross profit is – the amount of money left over from the sale of products and services to pay your overheads. In the case of more than one product, it is essential to know which one makes the greater contribution to paying your overhead costs.
So when a financially skilled business coach performs a diagnostic review of your business, he or she is going to look at all the inputs and processes that go into developing the Gross Profit line. Broadly, they are:
- Price – your pricing strategy
- Sales volume – your customer base
- Materials costs – your buying, storage & inventory strategies
- Labour costs – your human resource strategy
- Manufacturing cost – your creation, assembly & technical strategy
- Distribution & selling costs – your marketing strategy
Gross Profit reflects everything that goes into assessing demand, finding customers, communicating with them, creating your product or service, distributing and selling to your customers, and providing warranties and after sales service.
It also reflects everything to do with acquiring materials, recruiting and training people, safe processes, productivity, technical expertise and machinery to make the products and services sold.
So the next time you look at your Gross Profit line, remember that a good hard look behind the scenes will reveal a gold mine of information and gain competitive advantage.
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Until next time!