Finance for Entrepreneurs: Importance of Gross Profit

Revenue in a large way is a clear measure of what customers perceive as value. Hence revenue is a tangible way of evaluating value delivered. If we can safely assume that revenue is an indication of ‘value created’ for the customer, then we can also safely assume that gross profit is a reflection of ‘value captured’. These are not accounting terms, but they are reflective of how customers value a product or service and how business creates value for itself. This makes ‘Gross Profit’ an important metric to track in any business.

On the Profit/Loss Statement when we deduct ‘Cost of Goods Sold’ from Revenue, what remains is called ‘Gross Profit’ or ‘Gross Margin’ or ‘Contribution’. ‘Cost of Goods Sold’ refers to the costs incurred directly in the creation of the products or service, thereby the revenues.

‘Gross Profit’ is a widely tracked metric. This is primarily because ‘Gross Profit’ refers to the value that the business is able to create for itself in creating and delivering value to customers. If the ‘Gross Profit’ is high, then it means that people are willing to pay a premium to purchase the benefit. For example: people understand that the cost of manufacturing an iPhone is a lot lesser than the price that they pay for purchasing it, but customers are willing to allow Apple to make the money for creating and delivering the iPhone.

A large ‘Gross Profit’ also means that the business has enough margin to cover its remaining costs and also invest into the futuristic expenses. Growth requires money. Money typically comes either from the business operations itself or from debt or from equity investors. If the business has a large ‘Gross Profit’ then there is enough money to invest for future growth too. But if the business does not have enough ‘Gross Profit’ then the business has to raise money (debt / equity) to fund the future growth. Money from business operations (‘Gross Profit’) is free money for the enterprise, while the money from external sources comes at a cost.

Investors also show interest in knowing ‘Gross Profit’ simply because it is a reflection of the economic power of the product or service. This means that as the business scales the volume of margins will keep improving the self-financing ability of the business. This will reduce the need to raise or borrow funds from outside. This results in the existing investors’ valuation growing by leaps and bounds.

Thus for a number of reasons understanding and tracking ‘Gross Profit’ is an important aspect for every entrepreneur.

Think about it!

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