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This year is the year only you know. You’ve finally given the side gig you dreamed of a real shot and it’s starting to pay off in more ways than you thought. Now open a brick and mortar bakery. Now, you’re wondering if it’s time to take the next step and turn your side hustle into a full-time job, but you want to make sure it’s the right financial decision.
In this post, I will explain how you can use the gross profit formula to measure your company’s efficiency and profitability so that you can understand if you are making the right decisions. By subtracting your cost of goods sold (COGS) from your revenue, you can find your gross margin and make data-driven decisions about where to invest and where to save.
Calculating your profit margin will give you a clear idea of whether your side hustle is ready to turn into your main business.
How gross profit is calculated
Gross profit, also known as gross revenue, uses variable costs to measure efficiency. It is the remaining profit after deducting the costs associated with providing services and manufacturing and selling products. These variable costs, such as shipping and raw materials, change based on production levels, unlike fixed costs, such as salaries, rent, and marketing costs, which are constant monthly.
The higher the gross profit, the more efficient a firm is at using materials and labor to produce goods and services. Gross profit is an amount that can be calculated using the following formula:
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Revenue is the total amount of money a company makes from the sale of products or services over a specified period of time. This is your gross income before deductions and is shown on the top line of your income statement.
Cost of Goods Sold (COGS)
Cost of goods sold is the manufacturing cost associated with producing and providing a product or service. These are variable costs that do not consider fixed costs.
Cost of goods sold example:
- Production equipment cost
- transportation cost
- production utility
- raw materials
- Production labor cost
Examples of using the gross profit formula
Now let’s see how to calculate the total annual profit for a bakery.
First, you need to calculate your total income. This is the total amount customers paid for baked goods last year. A look at the annual income statement shows that total sales are his $375,000.
Then, calculate the COGS by looking at the money spent on labor, materials, and packaging throughout the year. You look at your income statement and determine that your COGS is $285,000.
Using the gross profit formula, $375,000 (revenue) minus $285,000 (COGS) gives the bakery annual gross profit of $90,000. You’ll notice that we don’t consider fixed costs at all. Fixed costs are later taken into account when calculating net profit.
How to calculate gross margin
Gross Profit Margin (also known as Gross Profit) is a gross profit calculation divided by total revenue and multiplied by 100 to determine the profitability of your manufacturing and production processes. You can use the following formula to calculate gross margin:
Gross Profit Margin = [Gross Profit / Revenue] ×100
Gross profit margin is a way to show gross profit as a ratio or percentage instead of money. This can be calculated on a monthly or yearly basis using the Income Statement, but to really get a sense of how the company is performing, you need to compare profit margins to previous months or years. This will allow you to see if your margin is increasing or decreasing and inform your decision to make adjustments if necessary.
Examples of using the gross margin formula
Using the same income statement we used before, let’s calculate the gross margin. Subtracting $285,000 (COGS) from $375,000 (revenue) gives us a total profit of $90,000.
Now divide that $90,000 by $375,000 of gross income. This gives us 0.24 and we multiply it by 100. This equates to 24%. This means the bakery has an annual gross profit margin of 24%.
gross profit and net profit
The key to understanding a company’s financial health is knowing its gross and net income (also known as gross revenue and net income). Gross profit measures the productivity of the manufacturing and production processes, while net profit measures the productivity of the company as a whole. To find net profit, use the following formula:
Net Income = Revenue – Total Expenses
Total Cost = Cost of Goods Sold + Taxes + Overhead
There are other fixed costs here. Let’s look at the income statement again and calculate the net income for the year.
Looking at the income statement, we see that the COGS is $285,000 and the total cost is $80,000. Add them for a total cost of $365,000. Now subtract $365,000 (total costs) from $375,000 (revenues) for a net profit of $10,000 for the year.
How to calculate net profit margin
Net Profit Margin, like Gross Profit Margin, is a way of stating net profit in a ratio or percentage. It can be calculated using the following formula:
Net Profit Margin = [Net Profit / Revenue] ×100
Looking at the same income statement, we can calculate the net profit margin by dividing net profit of $10,000 by total revenue of $375,000. This gives us 0.02, which multiplied by 100 gives 2.7%. This means that the bakery’s annual net profit margin is 2.7%.
average profit margin
So once you’ve figured out the gross margin and net margin, how do you know if it’s good or not? average profit margin will help you determine if you are on the right track or need to make adjustments.
Comparing the bakery’s 24% gross and 2.7% net profit margins with the average retail (grocery and food) industry profit margins of 25% and 1.1% reveals the following levels of profitability: I am where I should be.
How to improve your profit margins and grow your business
Knowing your gross and net profit margins allows you to make important financial decisions for your company based on data. If you compare your gross profit margin to the industry average and find that it is lower than it should be, you can:
- Boost your productivity: Consider how you can serve more customers in less time by fine-tuning your processes for greater efficiency. For example, you can create one batch of frosting that can be used for multiple types of cupcakes, rearrange your assembly line to save time, or prepare dry ingredients for recipes ahead of time.
- Reduce cost of goods sold: Reduce labor costs by training employees in multiple skills rather than hiring additional employees, find cheaper ways to source materials such as buying in bulk, or find cheaper alternative shipping methods.
- Price increase: Products can be priced higher to offset costs, especially if the economy is unstable. But be careful not to raise the price too high and lose sales.
Evaluating your company’s uptime and profitability will help you make the right decisions and see if you’re ready to turn your side hustle into a full-time business.
Creating a business budget is a great way to plan your expenses and track your cash flow, so you won’t be surprised by your year-end profit margins. Download the free Mint app to track your business goals, create budgets, see where your money goes, and get one step closer to financial freedom.
Save more, spend smarter, get more out of your money
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