Hi, everyone. It’s Nishi Patel from N-Accounting. I hope your have a great day. And in today’s video, I want to talk to you about what is gross profit and why does it matter?
So a lot of you may have accounting software and when you go to that accounting software to categorize your expenses, you may notice that you have a few choices in terms of where to categorize those expenses to. And one of the most interesting things about those choices is they tend to be split into two groups. There’s a group called the direct costs. You may recognize it containing things like materials and subcontractor fees, and there’s a group contain your overheads. And you might recognize that as a group containing things like your rent, your accountancy fees, your advertising costs.
So when you categorize expenses in your accounting software, you’ve got a choice of which one of those groups to put it under. And a lot of people don’t really understand the relevance of those two groups. They’re just like, I’ll just pick the category that sounds about right, and stick it there, which is a reasonable assumption to make. But I wanted to help you understand what the point of those two groups are and how they relate to gross profit.
So the first group, the one we call direct costs, otherwise known as cost of sales, it contains things like expenses in your business that relate directly to the sale. The way to look at that type of expense is to ask the question, if I didn’t make this one sale to this customer, would I still have that expense? If the answer is, yes, it probably doesn’t belong in that group. It’s more of an overhead. For example, if you didn’t sell anything tomorrow, would you still have to pay the rent on your premises? Would you still have to pay your accountancy fee? The chances are yeah.
But the other side of it is, if you sold to of something tomorrow, would you have to pay for materials. The chances are yeah, you would have to pay for the materials. But if you didn’t sell anything tomorrow, you wouldn’t have to pay for the materials to make those things. So the thing is, the materials, anything that you have to use, it could be ingredients if you’re a chef, it could be bricks if you’re a construction company, anything that goes into the end product that’s directly linked to the number of that end product you sell should sit within cost of sales.
So the reason why that’s important is because that helps you work out your gross profit and your gross margin. So think about it this way. If you take your sales figure, let’s say you sold £1,000 of stuff, and the materials that went into making that £1,000 of stuff costed £500, you’ll be left with a gross profit of £500. So 1,000 minus 500 will leave you with a profit of 500. That’s in gross profit. You haven’t factored in your overheads yet.
So let’s talk about why the gross profit is important. Well, the gross profit is important because it’s possibly the biggest indicator that your pricing strategy and the amount you’re charging for your customers is effective. It’s also an indicator that the deals that you’re getting with your suppliers for those raw materials is healthy as well. But most importantly, the reason people really look at the gross profit is it gives an indicator of, is this business sustainable or not?
If you think about it, if you’ve made a loss at the gross profit stage, you sold something for £1,000, but it actually cost you £1,200 of materials and direct labor to produce, then you’re selling something for less than it is worth. So this is why understanding your gross profit is so important because it helps you understand if you’re actually making enough money at the very basic price level to start covering your overheads, but more importantly, to start contributing to your own lifestyle.
So what I’ll do is I’ll do another video just about overheads and why they’re important and how they feed into things like net profit. But in this video, the takeaway point I really want you to have is that firstly, get your accounting software in order. If you aren’t putting things in the right pace, or you don’t have the right categories set up, you’re never going to understand gross profit, which means you’re never going to understand if you’re actually charging enough. So if you want help with that or anything else I’ve discussed in these videos, get in touch, book yourself in for a strategy session and we’ll go through it. All right, thank you. Have a great day.