October 09, 2017
Gross profit is an often misunderstood concept in business. Gross profit is found on the income statement, or the profit and loss statement as it is also known.
Basically, it is what’s left over after you subtract the cost of goods from sales. Gross profit is the amount left over to cover fixed expenses or overhead as it is often called. The goal is to have enough gross profit to cover overhead expenses and make a net profit, commonly called the bottom line profit. Otherwise, you will have a net loss unless you just breakeven and have no profit or loss. Cost of goods are the materials and applicable direct labor needed to produce or sell the goods. In a service business, it consists mainly of direct labor and may be referred to as the cost of service.
Obviously, the goal is to increase gross profit, or at least meet the standards for gross margin in the industry, which is gross profit dollars expressed as a % of sales. It is helpful to express gross profit in terms of % of sales in order make comparisons between periods, or as a comparison to industry norms. Below is a discussion on some ways to increase gross profit dollars and gross margin %.
Gross profit can be increased by raising prices which is difficult for most small business owners. There is a natural reluctance to raise prices because of competition and because of the fear customers will push back and leave. Keep in mind that in general, inflation alone is 2% per year, meaning your cost of goods and labor could be rising by that amount or more. There is an adage that a business should raise prices until they feel a little resistance.
Reducing the cost of goods can increase gross profit. Opportunities to reduce the cost of goods may appear if inventory suppliers are shopped, or even by asking a current supplier for a slightly lower cost. Make sure purchases are in the quantities that provide for the best price while maintaining inventory control. Watch closely the level of inventory waste, as reducing this can increase your gross profit. Keep in mind to look at the total cost of goods, as purchasing lower cost goods from a substandard supplier could result in higher costs in the long run because of delivery and quality problems.
If selling multiple products, analyze which products produce higher gross margins and take steps to sell more of them if it is advantageous to customers, or find new customers for the higher gross margin items. This will change the sales mix, and give higher overall gross margins. Consider introducing new higher gross margin products or services to the sales mix as well.
Gross profit is often referred to as ”top line profit”, which must be maintained in order to produce the necessary net profit or “bottom line profit”. Be careful to maintain your gross margins. The ASU SBDC can help by providing industry standards for profit and expenses in any industry.
“Business Tips” was written by Mr. Dave Erickson, Director and Certified Business Advisor, of Angelo State University’s Small Business Development Center. For more information on the topic of this article or the services of the ASU · SBDC, contact him at David.Erickson@angelo.edu