People who start businesses do so to make money. Typically, someone doesn’t decide to provide a product or service with the intent of giving it away for free. Even worse—to lose money on it. Unfortunately, that very thing happens sometimes. Some excellent products and services have failed to keep the company afloat. The culprit for this is often the lack of acknowledgment of the gross profit (GP).
So how can one small thing sink a ship so quickly? While the gross profit, compared with other factors of the equation, is a little thing, it’s also mighty. The gross profit is the remainder when you subtract the cost of goods sold from the sales received from your product or service.
While that may sound simple, it’s essential to get into the nitty-gritty about the cost of goods. That way, you’ll get good at calculating GP, and, in the end, profit the most.
It’s All in the Equation
The equation for calculating GP is actually quite simple:
- Sales – Cost of Goods Sold = Gross Profit ($)
After calculating GP, we turn the dollar amount into a percentage to determine the gross profit margin.
- Gross Profit / Sales = Gross Profit Margin (%)
The higher the percentage, the more money you are actually making.
A Juicy Gross Scenario
Let’s take another look at what it takes to calculate gross profit with a fictitious math story.
One summer, after tasting her mom’s healthy smoothie—made from organic fruits and veggies—nine-year-old Jane decided to freeze the drink and save it for later. When she was able to pop the smoothie out and hold it upside-down on a straw, an idea was born: a healthy popsicle!
Naturally, she started a small business selling the cold, delicious treat to health-conscious mothers and their children in the community. The $2.50-per-bar price tag seemed steep, at least compared to other $1.00 popsicle and ice cream bars that were sold from the ice cream truck and at the pool. The price of her treats, however, didn’t seem to hold Jane down—she sold 8,000 Juicy Jane bars the first summer, to the tune of $20,000!
Now, before you quit your job to open a healthy popsicle company, we need to look at this without rose-colored glasses. That $20,000 is the first part of the equation—the total sales. If we want to have a better idea of the cash in Jane’s little bedazzled purse, we need to determine the second part of the equation—the cost of goods sold.
The Cost of Goods Sold
Anyone knows (well, at least Jane knows) that to make a tasty, healthy smoothie, it needs to have strawberries, cucumbers, spinach, pineapple, banana, Greek yogurt, and orange juice. Oh, and it all needs to be organic, of course.
Jane calculated that her mom can blend up a batch of these seven ingredients and pour out 25 popsicles to pop into the freezer, ready for sale the next day. The cost of ingredients per 25 popsicles is $19.50, which breaks down to $.78 per popsicle.
Now, I see your wheels turning. You just did a little math, and used the equation to calculate the gross profit, didn’t you?
- $2.50 (Jane’s price per popsicle) – $.78 (cost of ingredients for a popsicle) = $1.72 gross profit! That’s a 69% gross profit margin! Cha-ching, cha-ching!
Not so fast! Consuming a Juicy Jane Bar that way will give you brain freeze.
Before getting too excited for Jane, we’re going to dig a little deeper.
This is where things start to get trickier because it’s easy to forget that Jane used her babysitting money to purchase a cute little cooler with wheels and umbrella at the beginning of the summer ($250 after tax). In other words, while the barrier to entry into this popsicle business was low, it still required a little cash up front to launch.
Additionally, what about the dry ice Jane’s dad picks up for her each day ($12/per day)? Also, the fact that Jane doesn’t feel right about making her mom slave away (such a considerate daughter!), without throwing her a bone ($8.00/hour x 2 hours per day = $16.00 per day in labor)? Jane can also anticipate that with all the spinning that blender is doing, it’s going to poop out eventually. A good, industrial-powered blender will easily set Jane back $800-$1,000.
Go ahead and swallow. Gulp. This is where you fully realize the cost of goods sold. You see, certain things will be fixed costs. In a traditional workplace setting, these fixed costs would include things like:
- Office supplies and utilities
- Wages, taxes, and benefits for office people
- Marketing expenses
In Jane’s situation, however, most of her costs are variable—they are likely to fluctuate over time. Common variable costs among businesses include:
- Utilities for manufacturing
- Depreciation of equipment or machinery
Due to the variable cost of organic produce, Jane is always shopping around to find the best prices and trying to be mindful of buying produce that’s in season. This is how she combats the variable cost of materials, to keep a healthy gross profit margin.
An alternate way Jane manages costs to keep her gross profit margin nice and thick is by remaining mindful of the efficiency of her business operations. Encouraging employees to practice proper time management techniques (i.e., telling her mom to record her telenovelas and watch them as a reward after she finishes blending and pouring) allows her to produce more in a day, which translates to more bang for her buck.
The Gross Profit Margin
So, what would be a good GPM for Jane’s popsicles? Well, that answer differs from industry to industry. It’s tricky to estimate the average GPM or what a healthy GPM would be in the popsicle business, because popsicles are sometimes lumped under ice cream, and sometimes categorized independently as popsicles.
Besides, there are many different ways of selling them (in stores, in vending machines, from carts, from trucks, etc.), so identifying an accurate GPM for popsicles is like trying to find a spec of dirt on a strawberry. This is commonly the case for many products and services, so if you want to find out the average GPM for your product or service, you will need to do little research.
Nevertheless, let’s say that we want the baseline to be that operating costs are met, with enough left over for Jane to be able to call herself a real business woman by the time 4th grade starts in the fall. Jane wants to make $100/per day for her efforts. Since she brings in $500 per day in sales, she will need a 20% gross profit margin to achieve her goals.
Let’s use what we know to find out how close Jane is to that 20% GPM:
- $20,000 – popsicle sales for the summer
- $250 – cooler with an umbrella
- $480 – dry ice
- $640 – mom’s labor
- $6,240 – materials (ingredients for smoothies)
- $112 – materials (popsicle sticks)
- $480 – materials (plastic wrappers)
- $200 – utilities (additional cost of electricity)
- $900 – a cushion for the cost of the new blender
- = $10,698 gross profit
Now, the moment of truth. Jane’s gross profit margin is….. 53%. So, she’ll pocket approximately $267, which makes her a bonafide businesswoman (well, in her 9-year-old eyes, anyway)!
Here are a few other things to keep in mind:
1) Besides all of the materials and operating costs mentioned above, Jane also needs to consider the unexpected. This can include exchanges, throwaways, and dissatisfied customers who would like a refund. Even Juicy Jane can’t make everyone happy, so she should be prepared to turn some of that profit back into the business.
2) If Jane’s business should expand someday, depending on whether she is thinking about adding office workers or warehouse workers, the salaries could be fixed or variable. While her mom is her only employee, the salary remains fixed. Other employees, however, will want to know that they will be compensated for their hard work and loyalty with periodic raises. Remember, however, that both will have cost of living adjustments at some point over time, so don’t forget to account for that.
3) Never underestimate the requirement to pay taxes. Considering how profitable Jane has become, it’s wise for her to keep Uncle Sam in the loop. It would be terrible for Jane to get chased down for tax fraud, so not only does she need to remember to withhold Federal Income Tax on her employee, but she will also need to withhold and match FICA. That tax liability will absolutely affect the GPM.
Juicy Jane is Profiting the Most
At the end of the summer, Juicy Jane appears to be quite a profitable business. While Jane is undoubtedly a sweet girl, she didn’t get into the business world to become a philanthropist—she set out to make a buck. Though she probably had to give out a few popsicles for free, the good news is that there was plenty of room in her gross profit to allow generosity, and still make money. Jane’s acknowledgment of the small-but-mighty gross profit margin allowed her to not only keep her business afloat but to also earn a reputation and build a brand that kids all throughout her community will look forward to indulging in for summers to come.