When it comes to real estate and business, a few formulas and numbers are essential to know. For example, most people should know how their profit, their margin, and, for real estate, metrics like cap rate and IRR (internal rate of return) are essential. One powerful but sometimes overlooked formula is the gross profit formula (also known as the gross profit percentage formula). This single metric is super easy to calculate yet can tell you quite a lot about the health of your business.
Here’s what you need to know about this metric, plus how it can help guide your business decisions!
Gross Profit Formula: How to Calculate It
The gross profit formula is straightforward to calculate. It is simply:
(Gross Profit / Revenue) x 100% = Gross Profit Percentage
Super easy, right!
In this context, your gross profit is the amount of leftover profit after subtracting your cost of goods sold and only your cost of goods sold. Your cost of goods sold (COGS) includes any expense directly attributable to that revenue (i.e. tenants paying rent). Labor and materials, for example, count as COGS, but internet access for your company likely would not.
Given this, the definition of gross profit is essentially “revenue – the cost of goods sold.” That means another way to write the gross profit formula is:
((Revenue – Cost of Goods Sold) / Revenue) x 100% = Gross Profit Percentage
As you can see, the gross profit formula is straightforward to calculate. Let’s see an example and also see how powerful it can be!
An Example Calculation
Let’s suppose you have a company producing widgets. They make one product, The Widget 3000. This product sells for $100 each, and it costs an employee one hour to complete the widget at $20 per hour plus $20 in raw materials. Further, suppose that the company sold 100 of these widgets in the past month.
In this toy example, the revenue for the company would be $10,000 in the previous month (100 sales x $100 per widget = $10,000). The cost to produce each widget is $40, so the company would have spent $4,000 as the cost of goods sold for the month (($20 labor + $20 raw materials) x 100 sales = $4,000).
Therefore, the gross profit for this company for The Widget 3000 would be $6,000 ($10,000 revenue – $4,000 cost of goods sold = $6,000 gross profit).
Using our gross profit formula above, we would have the following:
(Gross Profit / Revenue) x 100% = Gross Profit Percentage
($6,000 / $10,000) x 100% = Gross Profit Percentage
0.6 x 100% = Gross Profit Percentage
60% = Gross Profit Percentage
Therefore, in this example, the gross profit formula shows 60%. In other words, of every dollar in revenue, there were 60 cents left over after spending all required costs to make the product. This leftover money pays all other non-COGS expenses.
Why Is This Metric So Important?
This metric is quite simple to calculate, yet, as noted above, it’s potent and critical for business owners to know. Why is this the case?
There are three reasons why the gross profit formula is vital for business owners – including those in real estate – to know.
It Is the Best Way to Get a Quick Sense of Your Business’ Health
The most significant reason this formula is so important is that it is the quickest way to get a ballpark estimate of how your business is doing.
If you have a gross profit formula result of 40% in one quarter and the next quarter you have 20%, you know that, somewhere, your cost of goods sold shot up dramatically. That could be an early warning sign that something is amiss. Perhaps raw material costs shot up, and you need to raise your prices, there’s mismanagement on your business or property, or maybe it’s now costing people two hours to make the same widget when it used to cost them one. Either way, dramatic increases or decreases in this formula suggest fundamental changes in your underlying costs to produce these goods.
The Gross Profit Formula Helps You Ensure Improvements Are Working
In an ideal world, every business would have a gross profit formula percentage of 100% – every company wants to pay nothing to produce the products they sell or the services they offer!
However, practically, that will never happen. Produced goods and services always have some expenses associated with them. Still, companies try to optimize and streamline their costs to ensure they are as minimal as possible.
How does a company know if these optimizations are working? They should show up as a lower cost of goods sold if they are. For example, if a company switches suppliers and buys t-shirts for $10 a t-shirt instead of $20, the final product should have less of an expense in raw materials.
So, if that company calculates their gross profit percentage and finds that it went down, they know that optimization isn’t working. Perhaps the t-shirts are half off, but they are significantly harder to embroider, thus offsetting any savings with added labor.
It can be straightforward for a company to “optimize” but lose efficiency somewhere else in the pipeline. The gross profit percentage is a simple way to check that those optimizations are reducing the costs necessary for production!
Gross Profit Formula: A Powerful Metric to Know
As noted above, the gross profit formula is a powerful metric to know and an easy one to calculate. It doesn’t tell the whole story. It doesn’t say if the company is profitable or indicate anything about its overall financial status. Indeed, a company selling $10 million with a 4% gross profit percentage is better off than a company selling $100 worth of goods at a 40% percentage.
However, it is an excellent quick indicator of the overall health of the production pipeline. After all, the lower the gross profit percentage, the more volume you need to be profitable. And significant decreases in that percentage be warning signs of potential inefficiencies that need addressing.
Ultimately, like any metric, it’s one tool of many to measure a business’s health. Much like profit, EBITDA, and others, this is one that you should also add to your list of numbers to know!