Gross profit is gross profit, right? The math is simple enough. To calculate gross profit: subtract the cost of goods sold from revenue of the same time period to yield your gross profit. To calculate gross profit margin, divide gross profit by your total revenue from the same period and you have your figure. Unfortunately, there's more to it than that calculation. It should be that simple, but having scoured hundreds upon hundreds of small business income statements, our data shows it’s rare to find an accurate gross profit figure, let alone one an owner should trust.
- Profit. Owners, lenders, investors all want to know how much money is made relative to expenses. Gross profit is the answer. Accurate gross profit also reveals your net revenue and helps assess your company's financial health.
- Pricing. Gross profit tells you how much money you make on each item you sell. A high gross profit margin indicates strong pricing power and operational efficiency. Turn a blind eye toward this type of classification and you’ll lose your ability to determine whether a product/service is generating or losing cash, and to what degree. Poor pricing decisions often step from overlooking production costs or incorrectly categorizing variable costs.
- Benchmarking. An accurate gross profit enables an apples-to-apples comparison with benchmarked performance of the competition.
- Product/Service Mix. Understanding the relative gross profit for each product or service allows an owner to evolve an offering based on its relative contribution to profit.
Tip: For more on the distinction between gross profit and net profit, click here for tips on reading an income statement.
Consistent with many areas of accounting, choices abound when a bookkeeper enters expenses. It may surprise some that there’s not a set method for entering transactions, far from it. Yet most bookkeepers record expenses with a singular goal in mind: tax compliance. They shoot to minimize the tax bill and avoid getting into trouble with Uncle Sam. In such cases, the only accurate and useful summary lines on an income statement are revenue, gross income and taxable income. These errors don't just distort your taxes. They skew your gross profit margin formula, income analysis and pricing strategy.
Many owners miss the opportunity to harvest insights from their income statement, but it’s even worse when they make decisions based on incomplete or inaccurate information. For example, many owners assume they're calculating correctly, but their gross profit margin is often inflated due to overlooked operating expenses and misclassified costs.
Here’s how gross profit calculations are often misleading:
1. Classifying fulfillment cost as overhead
It’s common to see costs associated with building a product or delivering a service misclassified as overhead or General and Administrative expenses (G&A) costs as opposed to Cost of Goods Sold (CoGS). Such a misclassification doesn’t change the taxable income, but it will prevent you from evaluating your pricing.
When fulfillment costs are incorrectly categorized as overhead, it distorts the gross profit calculation. This misclassification may inflate the gross profit figure, making it appear that the company is more profitable at the production level than it truly is. Since gross profit represents the difference between revenue and the direct costs of production, including fulfillment costs in overhead rather than CoGS means that these variable costs, such as raw materials, direct labor costs, and shipping, are excluded from the gross profit calculation.
2. Mixing business with pleasure
There are cases where the line between a business or personal expense can be blurred. Perhaps a case can be made for expensing some of your vacation expenses if you visited a client while on the road, but generally speaking clean margins start with clean books so avoid co-mingling the two so you can analyze the performance of your business. When personal expenses get mixed in, your company's income statement no longer reflects true net income.
3. Closing Infrequently
The phrase “close your books” means entering revenues and costs for a particular period with the objective of not making additional changes. These “closings” are for internal management purposes and your accountant will typically weigh in at year end, making adjustments as necessary. If you don’t close your books monthly, or at least quarterly, you may miss small issues as they arise and lose the opportunity to prevent them from growing into larger issues.
4. Ignoring timing
We’ve seen many financials where attention was not paid to customer or vendor invoice dates. Transactions are often entered for incorrect (eg: prior) periods or bunched into a single period even though they were incurred over multiple periods. Timing does matter. Incorrect or inconsistently dated transactions will artificially increase or decrease the Gross Profit, as well as affect net sales and operating ratios that your income statement depends on.
5. Classifying overhead as cost of goods sold
Overhead or G&A expenses are often erroneously classified as CoGS. For example, it’s not uncommon to see owner’s compensation as part of CoGS. While it’s conceivable an owner contributes to product/service fulfillment, at least some of the owner’s compensation belongs in G&A. Leaving all of an owner's compensation in CoGS causes your gross margin to appear lower than they are, while understating fixed costs.
6. Not splitting accounts
Many times, all fixed overhead expenses are classified in G&A or CoGS accounts. However, some fixed costs such as rent and utilities may need to be split between CoGS and G&A. For example, a company that uses 50% of it’s building for staff that delivers a specific service should apply 50% of rent to COGS and remaining 50% of rent to G&A. Failing to split accounts accurately can obscure your real cost of goods sold vs. administrative overhead.
7. Failing to capitalize assets
Fixed assets over a certain value should be depreciated over a certain number of years according to the Generally Accepted Accounting Principles (GAAP). However, some bookkeepers expense these assets, causing Gross Profit to appear falsely low. The purpose of depreciating an asset over it’s useful life is to align the cost with the periods during which the asset generates revenue for you. We are not talking about a $250 computer, rather larger expenses that would materially change your monthly financial performance.
8. Classifying expenses inconsistently
Ambiguous, undocumented or unmanaged accounting procedures often lead to intermittent adherence to classification protocols. It doesn’t take many misclassifications to render a Gross Profit useless.
9. Viewing Gross Profit over a short period of time or a single period in isolation
Looking at only a month or single fiscal quarter may create a false impression since gross profit may fluctuate period-to-period. Looking at one quarter in isolation can also hide trends in your gross profit, particularly when direct costs fluctuate seasonally. Look across longer periods of time so the gross profit can factor in the typical ebbs and flows of a business. It's also advisable to compare the current period with past periods to pick up any trends that might require further investigation. While gross profit offers an initial view, tracking your net profit margin alongside it reveals a fuller story of your company's profitability.
You've heard the old adage: “Garbage In. Garbage Out.” Lackluster expense classification can lead to costly decisions. For example, including personal expenses might make it appear as though you can't afford a new hire, causing you to back away from a new opportunity you're not currently staffed to deliver. Harness the opportunity to use every day bookkeeping to build a foundation for reporting that can change the way you run your business. The resulting insights can and should be game changing.
THE DRIVEN INSIGHTS ADVANTAGE
Driven Insights is experienced in leading service businesses on the journey to leveraging financial and operating metrics to accelerate growth. Our bookkeepers and controllers are charged with much more than simply “doing the books” – they ensure each client understands and uses the insights we share.
Interested in learning more? See for yourself how Driven Insights can provide the insight and control you need to achieve your most critical goals by contacting us at info@driveninsights.com or 888-631-1124.
