When measuring the profitability and sustainability of your company, you need to know your gross profit and its margin.

These complementary metrics ensure your company is not only making enough money to stay in business, but remaining efficient while doing so.

Let’s look at gross profit first.

How to calculate gross profit

Gross profit is the accumulation of all sales a company has conducted throughout a period, also known as revenue.

That revenue is then subtracted from the Cost of Goods Sold, or COGS. You’ll need to determine your COGS before tackling gross profit.

With revenue and COGS at-hand, it’s time to determine your gross profit.

Here’s an example to further explain the formula:

• Company A recorded total revenue of $5.6 million at the end of the 2017 fiscal year.
• Company A figured its COGS and found it totaled $4.2 million at the end of the 2017 fiscal year.

$5.6 million - $4.2 million = $1.4 million gross profit

It’s important to understand that gross profit only factors a company’s variable costs, not its fixed costs. The above formula cannot be done accurately without making the distinction between the two.

What are variable costs?

A company’s variable costs include everything from raw materials, direct labor, production equipment, shipping fees, and even utilities used in the production cycle.

Essentially any cost that can be associated with the direct development of your product or service is considered a variable cost.

What are fixed costs?

A company's fixed costs include everything from payroll, employee benefits, marketing, advertising, third-party consulting, insurance fees, and even employee expenses.

Why are these considered fixed costs? Because they are indirectly associated with the development of a product or service.

Fixed costs are often referred to as “operating expenses,” or the money required to run a business outside of just producing.

Why is gross profit important to know?

Perhaps the most important reason to know your company’s gross profit is to ensure you’re making more money than you’re spending.

While this may seem obvious, many companies struggle to efficiently manage their spending on supplies and labor. Failing to do so over long periods of time can lead to operating in the red – which is not sustainable at all.

In the end, gross profit will provide you with a solid dollar amount of how much money has been made against variable costs.

While gross profit is important, it’s not always a clear indicator of year-over-year growth. This is why calculating for gross margin is equally important.

How to calculate gross margin

Now that you’ve figured your gross profit, it’s time to determine your gross margin.

Here’s an example to further explain the formula, using figures from earlier:

• Company A figured its gross profit earlier, equaling $1.4 million.
• Company A recorded total revenue of $5.6 million at the end of the 2017 fiscal year.

$1.4 million / $5.6 million = 25 percent

So now that we have our gross margin percentage, what does this mean?

Why is gross margin important to know?

There have been instances of companies seeing an increase in year-over-year gross profit, while at the same time seeing a decrease in growth and efficiency. This means the margin between operating expenses and profit is narrowing.

If that margin becomes too narrow, a company can fall into financial trouble. This is why calculating for gross margin is equally important.

A steadily rising gross margin helps investors and shareholders see that the company is growing at a profitable and sustainable rate.

Additionally, financial analysts can use gross margin to compare the success of your product or service with those in your industry. This comparison is made against a baseline percentage.

What is a good gross margin?

There is really no concrete percentage to determine a “good” gross margin, but as mentioned earlier, there are sometimes industry standards.

For example, many small businesses find operating between 25 to 35 percent gross margin to be sustainable. In retail, this could be as low as 20 percent.

In more profitable industries like hi-tech, healthcare, law, and financial services, this could range from 70 to 90 percent!

A “good” gross margin is really relative to the industry your company operates in, and the companies that are directly competitive to yours.

For companies looking to increase their gross margin percentage, they’ll need to retain more of its profit.

How to increase gross margin

When the goal is sustainable and profitable growth, there are a few paths companies can take to get there.

One path is through product markup, which is another way of saying “increase your prices.”

However, there is some drawback with marking up products. Over time, customers may find cheaper options elsewhere – leading them to competitors. Inflating the cost of your products too high could lead to an immediate loss of customers.

Another path is through reducing variable costs, or the costs associated with the development of a product.

Reducing variable costs, however, also has its drawbacks. For example, finding cheaper raw materials or cutting costs in the production cycle could lead to lower product quality. This could dissatisfy customers in the long run and affect brand reputation.

As you can see, increasing gross margin is much easier said than done. But for companies looking to thrive in competitive industries, seeing this growth is needed.

Made easier with accounting software

Gross profit and gross margin are fairly straightforward metrics, but acquiring all the pieces to calculate them isn’t so easy.

Fortunately, accounting software generates these reports accurately and can be quickly shared between CPAs and their clients.

Looking to try before you buy? Read our analysis of the top 11 free accounting software solutions available today.