One of the most important areas of a company's financial management is the calculation of gross profit.  However, it is the most misunderstood and overlooked areas of business.

It is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.  Profits directly affect revenue, which directly affects net income.

It can be calculated with this formula:

Gross profit = Revenue – Cost of Goods Sold

For calculating profit margin, this is the formula:

Gross profit margin = gross profit / revenue = (revenue – cost of goods sold) / revenue

Why are these calculations important?  They determine how much money made selling the products and/or services of your business.  However, there is a balancing act involved when managing gross profit and profit margins.  Too little profit margin results in bills not paid.  Too much profit margin and prices could be too high for customers to be willing to pay.

Determine Gross Profit

As you determine what prices you will charge, you need to determine the amount of gross profit you can earn.  That’s why you want to know all the key numbers: the cost of the products and/or services you will sell, the competition’s prices, and the industry’s average profit margins.  If you can find better prices without sacrificing quality, service or reliability, you need to be looking for those numbers as well.

The key principle is to lower your business’ internal costs so that profit margins can be higher.   If your business can figure out how to lower product or service costs and still be competitive in the market, your business will be more profitable versus the competition.