Gross profit is the money a business earns from sales after paying for the cost to make or buy its inventory, or products, but before paying operating expenses. A high gross profit is better than a low one for your small business. The gross profit formula -- net sales minus cost of goods sold -- is the same regardless of which inventory system a company uses. However, the calculation of cost of goods sold in the periodic inventory system differs from that of other systems.
In a periodic inventory system, a business updates its inventory and cost of goods sold accounts in its records only at the end of an accounting period. At this time, a business physically counts its inventory and uses the information to calculate its cost of goods sold. The periodic system is generally used by small businesses with limited inventory. In a perpetual inventory system, a business updates these accounts every time it buys and sells inventory, which makes their balances readily available without an inventory count.
Costs of goods sold in a periodic inventory system equals the inventory account balance at the beginning of the period plus the net purchases of inventory during the period minus the inventory balance at the end of the period. Net inventory purchases equals the total amount purchased minus any refunds or discounts you receive from suppliers.
Assume your small business had $500,000 in inventory at the beginning of the year, $350,000 in net inventory purchases during the year and $200,000 of inventory at the end of the year. Assume you had $1 million in net sales, which equals sales minus refunds and discounts given to customers. Your cost of goods sold equals $650,000, or $500,000 plus $350,000 minus $200,000. Your gross profit equals $350,000, or $1 million minus $650,000.
The higher your gross profit, the more money you have available to pay for operating expenses, such as utilities and wages. Strong gross profit can lead to more overall, or net, profit. Compare your gross profit over different accounting periods to monitor your progress. To improve gross profit, you can reduce inventory costs, increase your sales volume or raise your prices. In the previous example, if you reduce cost of goods sold to $600,000 and increase net sales to $1.1 million, your gross profit would rise to $500,000.
