Your small business earnings are not accurately represented
by your gross income. Businesses must deduct overhead costs from revenues in
order to calculate actual gross profit. Overhead costs include the costs of
manufacturing things, the wholesale cost of buying commodities, and the
equipment required to generate items for sale.
In the corporate world, total revenue is not everything. A
company with $1 million in annual sales but only $100,000 in expenses generates
less money overall than a company with $1 million in annual sales but only
$10,000 in expenses. In general, gross margin or gross profit are the two
methods used to determine profitability because they are slightly different.
Describe gross profit
Gross profit, which is also known as net income, calculates
a company\’s profits in dollars after deducting its production costs. In other
terms, a company\’s gross profit is equal to its entire sales income less its
manufacturing costs, often known as cost of products sold (COGS).
For instance, if a kid runs a lemonade stand, the kids make
$50 in total sales. However, they spent $25 for ice, lemonade mix, sugar,
lemons, and paper cups before they opened for business. Their daily gross
profit is $25 after deducting this $25 COGS from their $50 in total sales.
Describe gross margin
Gross margin, commonly referred to as gross profit
percentage or gross margin %, assesses the financial effectiveness of an
organization. It calculates the amount of profit you make for every dollar of
sales. More specifically, to get a percentage figure for your gross margin,
multiply your gross profit by the sum of all your sales revenues and divide by
100.
In the lemonade stand example, the kids\’ gross margin is
calculated as $25 divided by $50 (their total sales), multiplied by 100, so
their gross profit (their total sales minus their COGS) is $25. Therefore, the
lemonade stand has a gross margin of 50%. In other words, half of the money
made at the lemonade stand was used to pay for supplies like sugar, cups, and
lemons, with the remaining half going to the kids\’ piggy banks.
Comparing gross profit with gross
margin
Uses
A company\’s profit is determined using both the gross margin
and the gross profit. The distinction is that although gross margin is a
percentage, gross profit is a flat amount. Both measures are useful for various
purposes.
You can use gross profit to:
To estimate your purchasing power. Calculating gross profit
allows you to know in precise dollar amounts how much you will make after
expenses over a specific time period. This can help you determine how much
money to put back into your company. A monetary amount is more useful than a
percentage when making purchases. For instance, by understanding gross profit,
you can estimate how long it will take your company to recoup the cost of its
pricey new juice machine.
Examining variable costs Gross profit also demonstrates how
effectively you employ resources like labor, raw materials, and supplies—whose
prices change in accordance with your level of output.
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On the other hand, you can use gross margin:
When making long-term plans. If your gross margin is
consistent over an extended period of time, you know that you can forecast with
reasonable certainty a certain gross profit on each dollar of sales. As you
have a better understanding of your company\’s financial situation, knowing your
gross margin can help you run your operations more efficiently.
To grow your company. Having a baseline for predicted
earnings per dollar of sales gives you useful information that you may use to
justify an expansion or request more funding, even while line items like
variable costs and direct expenses change over time.
Calculations
The formulas for determining gross profit and gross margin,
respectively, are as follows:
·
Sales revenue minus costs of products sold
equals gross profit (COGS)
·
Gross margin (%) is gross profit divided by 100
sales revenue.
Remember that your gross profit depends on your gross
margin, thus you cannot determine the latter without knowing the former. Gross
margin needs you to first know your gross profit, which you then divide by your
entire sales income, as opposed to gross profit, which can be calculated using
simply your total sales and COGS.
Final outcomes
Gross margin is expressed as a percentage, whereas gross
profit is expressed as a figure. Gross profit can be difficult to understand
without knowing a company\’s other financial indicators (such net revenue, for
example). If you don\’t also know the company\’s total revenue for the same time
period, the gross profit statistic is meaningless.
For instance, the gross profit of $25 appears quite
differently depending on whether the lemonade stand sold drinks valued at $50
or $500. The gross profit in both situations is the same ($25). However,
because it provides a percentage rather than a precise dollar amount, gross
margin provides more information about the financial health of your business.
The gross margin is 50% if the lemonade stand made $25 by selling $50 worth of
drinks; it is 5% if it sold $500 worth of drinks.