Whether you’re a freelancer or small business owner, you should always be evaluating the financial health of your operations.
The National Association of Small Businesses found that two of the top three challenges of running a small business are economic uncertainty and a decline in customer spending.
Setting strategic goals and keeping yourself on track to complete them is an excellent way to avoid these challenges.
To do so, you need to concern yourself with Key Performance Indicators, or KPIs.
According to Klipfoloio, a KPI is “a measurable value that demonstrates how effectively a company is achieving key business objectives.”
Additionally, many financial KPIs are on documents like your income statement and balance sheet.
You must understand what these terms mean, why they’re essential, and how to go about calculating them.
One of the most important KPIs when starting your own business is the gross profit margin.
Below, you’ll find a complete guide to how to calculate gross profit rate and why you should consider doing so.
What Is Gross Profit?
Before jumping into the gross profit margin formula, it’s better to understand what gross profit is and how it relates to your business.
However, to understand gross profit, we must first start with expenses.
You can broadly organize your business expenses into two primary categories, operating and non-operating.
Operating expenses, often referred to as production costs or cost of goods sold (COGS), are all of the costs associated with bringing a product or service to market.
The most common example is raw materials and direct labor costs.
If you’re a freelancer working remotely, these expenses can include things like research and development, marketing expenses, and administrative expenses.
Non-operating expenses, on the other hand, are indirect costs.
You can’t attribute these to any one product or service.
Instead, they are the costs that are necessary to a business’s functioning, even if they’re not related to the core operations of the company.
Examples of non-operating expenses include:
- Interest charges
- Costs associated with borrowing
Gross profit is a figure that measures a business’s profit after accounting for operating expenses.
The theory is that you can put whatever you have remaining after calculating your gross profit toward non-operating expenses.
So if you wish to understand your company’s gross profit better, you’ll first need to comprehend operating expenses.
Why Is Gross Profit Margin Important?
The gross profit margin ratio is vital as a “building block” KPI.
If you would like to turn a net profit, the gross margin percentage is an excellent place to start.
The ratio demonstrates whether your total sales are enough to cover your costs.
There’s no black-and-white answer as to what a proper gross profit margin percentage should be.
You will want to compare your gross profit percentage to other firms in your industry.
This will give you a better indicator as to whether you’re successful.
If your gross profit is below the industry average and you discover that you’re suffering from low margins, you’ll need to go back to the drawing board.
You could then craft a strategy that meets your business’s needs.
For instance, you could potentially invest more in customer retention to help drive total revenue.
You could also comb through variable costs to determine where you can cut expenses.
For instance, perhaps you’re putting a lot of money into marketing efforts, but you realize that you’re losing money because you can’t keep up with product demand.
You could allocate marketing funds to hiring new employees instead.
Both are operating costs, and your gross margin will be the same.
How to Calculate Gross Profit Margin
Are you ready to begin calculating gross profit?
Consider these gross profit formulas.
First up is the basic equation for gross profit, which is:
Gross Profit = Revenue – Cost of Goods Sold
In this example, let’s say that your company earns $500,000 in revenue and that your costs of goods sold were $350,000.
Gross Profit = $500,000 – $350,000 = $150,000
There is also the gross margin — used interchangeably with gross margin percentage or gross profit rate — which provides you with a percentage reflective of your income.
The equation for the gross profit margin is:
Gross Profit Margin = (Revenue – Cost of Goods Sold) ÷ Revenue
You can multiply the resulting number by 100 for a percentage.
So for instance, using the above example:
Gross Profit Margin = ($500,000 – $350,000) ÷ $500,000 = .3, or 30%.
Some industries, like food and beverage stores, have gross profit margins in the single digits.
Other firms, like banks and healthcare institutions, have sky-high profit margins.
The type of industry that you’re in will determine whether your gross margin is successful.
How Does Gross Profit Compare to Other Ratios?
Gross profit is an example of just one type of KPI that business owners can use to measure the financial health of the company.
One of the other most basic KPIs is net profit.
Net income and gross income are different because the former accounts for the removal of taxes and expenses.
Gross profit gives you a snapshot of how much you’re earning vs. how much you’re spending for the production of a product.
Net profit shows you how much of your revenue yields a profit.
Your net profit margin will always be lower than your gross profit margin.
Much like with gross profit margin, whether or not your margins are “good” or “bad” depends on your industry.
Net Profit = Revenue – Cost of Goods Sold – All Other Expenses – Interest – Taxes
To calculate net profit margin, all you need to do is divide by revenue.
Net Profit = (Revenue – Cost of Goods Sold – All Other Expenses – Interest – Taxes) ÷ Revenue
Another financial KPI that you’ll want to consider is operating profit.
Operating revenue is quite similar to gross profit.
However, operating profit provides a more detailed snapshot of how much you earn from each good or service that you sell.
As you’ll recall, gross profit accounts for the total dollar amount of all revenues.
Operating profit, on the other hand, only deals with your sales revenue from goods and services that you’ve sold.
It does not account for income from things like investments and interest.
The formula to calculate operating profit is:
Operating Profit = Operating Revenue – Cost of Goods Sold – Amortization – Depreciation
Amortization represents the fixed loan payments that you make.
Say, for instance, your company prints t-shirts, and you needed to purchase a machine that allows you to do so.
You pay $50 a month toward a loan that allowed you to buy this equipment.
You’d factor those payments into your operating profit equation.
You’ll also need to account for depreciation.
Depreciation represents an asset’s loss of value over time.
For example, the first time that you use the t-shirt printing machine, it loses value.
You could no longer sell it to another company as “New,” nor could you return it.
One of the interesting things about operating profit is that you can use it to compare the success of one product to another.
To do so, you’ll first need to sort the operating revenues and expenses for each product or service that you offer.
After calculating the operating profit, you can see which are most profitable.
Doing so allows you to make strategic adjustments to your company.
Perhaps you realize that one product is not yielding as much as you thought, or that one product is outperforming the other by a considerable margin.
Maybe you’ll need to cut the underperforming product or re-allocate resources so that it becomes more profitable.
The operating profit rate gives you a more in-depth look that the net profit rate and gross profit rate don’t provide.
Get Your Company Finances in Order
Whether you’re a freelancer or an experienced business owner, it’s never too late to start fixing your finances and improve your company’s profitability.
Doing so can help ensure that your company remains profitable, no matter what bumps in the road may come along.
If you don’t have much familiarity with financial ratios, you should consider using accounting software like QuickBooks or Wave.
Not only can you categorize and track expenses with this software, you can also calculate KPIs like gross margin.
Accounting software comes with tools like profit margin calculators that streamline the process so that you don’t have to spend hours pouring over complicated financial statements.
When it comes to your operation’s financial health, the sooner you get started, the better.
You can begin calculating profitability ratios in no time to give you a clearer picture of your firm’s finances and help improve your bottom line.