Why is calculating your business’s gross profit and gross profit margin important? To answer this question, let’s first revisit a conversation I recently had with a friend. He and his spouse are trying hard to save money: their goal is to sock away $35,000 in the bank, which will ultimately be used for a down payment on a home.
I commended my friend on this noble goal. Our conversation then turned to the money-saving strategies he and his spouse were using. For example, they had canceled 2 of their 4 streaming services. They’d also started brewing coffee at home and cutting down on their daily expenses at coffee shops and restaurants.
I then asked how much money my friend was saving each month with these strategies—and he had no idea. He and his spouse have never used a budget and don’t monitor their credit card statements, so they don’t know how much they were spending before and are potentially saving now.
Many small business owners use a similar approach to my friend. They put great effort into managing their finances but lack any degree of analysis. Are their strategies working? Who knows? They simply aren’t utilizing any metrics that would enable the business owner to gauge the effectiveness of their efforts. This approach banks on good intentions and a healthy dose of optimism instead of the hard numbers that would empower an efficient and effective approach to saving money.
Calculating a business’s gross profit and gross profit margin is an easy way to track financial performance. These 2 metrics are among what are often referred to as key performance indicators (KPIs).
“Big businesses have been using KPIs to measure their success for years,” says a financial report from Forbes. “Yet many small businesses ignore this less-understood acronym…A manager can see if an employee is improving and if they are outperforming other employees by looking at their KPIs and tracking their results. But if you are self-employed or running your own firm, who is there to tell you what your KPIs are? Are you letting your business run you, or are you running your business? Moving from salesperson to businessperson or moving from a small business to a larger business requires a change in perspective. And one great place to start is to figure out your KPIs.”
Gross profit is a metric used to assess how much of your revenue remains after you’ve taken out the costs of making and selling your products or services. Gross profit is expressed as a dollar amount, allowing you to see a clear picture of how efficiently your business operations are running.
So how do you calculate your gross profit? The formula is fairly straightforward:
Net Sales – Cost of Goods Sold = Gross Profit
Here’s an example of gross profit in action. If your business makes and sells tie racks, your cost of goods sold might include the materials you use to make the tie racks, the labor required, the equipment used in the process, and the utility expenses for your factory. If you ship the tie racks to customers, you’d add those costs in as well.
Once you’d tallied all your costs related to the goods you sold, you’d subtract that amount from your net sales. What remains would be your gross profit.
Gross profit margin, on the other hand, is a KPI that reveals insights in the form of a percentage. It’s a metric that often goes hand-in-hand with gross profit. Here’s the formula:
Net Sales – Cost of Goods Sold / Net Sales = Gross Profit Margin
Your gross profit margin also combines all the costs that come with selling products or services and removes these costs from your revenue, allowing you to see how effectively your pricing strategies bring in money for your business.
Ideally, you’ll have a favorable margin that reveals a substantial percentage of your revenue translating into profit. A high gross profit margin suggests that your business excels at delivering products or services to customers. The benchmarks vary from industry to industry, but a 10% gross profit margin is often considered good. When you get into the 15–20% range, it’s really something to write home about.
As you carefully monitor your gross profit and gross profit margin, you’ll be able to improve efficiency and save money. Additionally, you’ll establish more reliable and efficient processes that benefit your customers. And everyone knows that when customers are happy, the business owner is inevitably happy as well.
“The customer experience on the outside is shaped by what is happening on the inside,” explains business expert Blake Morgan. “Internal efficiencies in the form of smoother internal processes and procedures translate into external customer experience improvements. To create a great external customer experience, the best solution is often to focus on internal efficiencies…Operational efficiencies run the gamut of ways to make processes run smoothly, and when done correctly can have a tangible impact on the business.”
All this focus on your internal processes is important, but it shouldn’t overshadow the relevance of looking outside your business. Part of understanding your business’s efficiencies is knowing how they stack up against the competition. Your KPIs are critical to contrasting your performance and finding areas for improvement.
Of course, you can’t stack your business up against others unless you have relevant data. You’ll never find a competitor’s gross profit margin listed on their Facebook page, but there are typically sources available to find it. For example, equity research analysts and ratings agency data experts compile industry reports that will often contain what you’re looking for.
“It is important to conduct routine competitor analyses throughout the lifecycle of your business to stay up-to-date with market trends and product offerings,” says Business News Daily. “A competitor analysis can reveal pertinent information about market saturation, business opportunities, and industry best practices. It is also important to know how your customers view you in comparison to your competition.”
When your research exposes flaws in your operations, you shouldn’t feel dejected. Instead, celebrate the fact that you now have the insights needed to make improvements. You can learn from your competitors’ strengths and apply similar strategies to your business.
Improving your operational efficiency will always be a journey, not a destination—so it’s imperative that you continually review your gross profit and gross profit margin KPIs and then analyze your competitors’. This process of refinement is not only the key to better revenues—it will also yield a more fulfilling and memorable experience for customers.