What is gross profit?
Gross profit measures the money left from the sale of your goods or services, once the direct expenses used to generate them are deducted (e.g. labour and material costs). It varies across products and sectors and is often used to measure the profitability of a single product.
“Gross profit is important as it indicates whether your pricing and purchasing strategies facilitate a return and make the business viable,” says Nila Khan, Business Advice Manager at the ICAEW. Gross profit should not be confused with operating profit, which is calculated by subtracting operating expenses from gross profit.
Gross profit can also be understood as a percentage of your company’s revenue using the gross profit margin formula. Gross profit is generally calculated including only variable costs in its deductions.
Where to find gross profit on the income statement
You can find gross profit on the income statement, typically after the revenue section and before the operating expenses:
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Gross profit formula
Gross profit is a measure of a company's profitability after deducting direct costs like raw materials and labour. However, it excludes fixed costs such as rent and insurance because these are not directly tied to production. Gross profit shows how efficiently a company can generate revenue from core operations.
Gross profit can also be understood as a percentage. Gross profit is calculated by subtracting the cost of goods sold (COGS) from total revenues. Simply, the gross profit formula is:
Gross Profit = Revenue – Cost of Goods Sold
Revenue
Revenue is the total amount of income your company generates from the sale of your products or services. It shows you clearly how much money you’re bringing in from your total sales. It does not include the costs of running your business, such as taxes, interest and depreciation.
Cost of goods sold (COGS)
The cost of goods sold refers to all the direct costs and expenses involved in producing or delivering your goods and services. It does not include indirect costs, such as staff salaries or sales and marketing. Below are some examples of COGS:
- Raw materials or parts needed in manufacturing
- Direct labour costs associated to production
- Shipping costs
- Time spent assisting a client
- Equipment costs involved in the production
- Utilities for the production facility
Gross profit vs gross profit margin
It's easy to think gross profit and gross profit margin are the same thing, but they are actually different ways of measuring profit. Gross profit shows the difference between revenue and COGS. Gross profit margin, on the other hand, is the percentage of revenue remaining after COGS has been deducted. Using this percentage margin is helpful for measuring how profitable your business continues to be as it grows, or for comparing against competitors or industry benchmarks.
Why is gross profit important?
Careful management of gross profit can ensure that the healthiest possible net profit is achieved, says Carl Reader, Chairman of D&T Chartered Accountants.
A high gross profit margin generally indicates you’re making money on a product, whereas a low margin means your sale price is not much higher than the cost. Several factors can impact gross profit, such as exchange rates, delivery costs and even the mix of products and services.
Gross profit can support small business owners in understanding what price to charge customers, says Khan. It can establish whether the cost of goods or services related to sales is low enough for profit generation. If not, profit can be increased through improved production efficiency, supplier negotiation for lower prices or price modification for customers. Additionally, gross profit monitoring aids in identifying annual performance trends in product sales to guide future strategies.
Understanding gross profit is an important first step for any business owner. Without it, it's almost impossible to calculate the break-even point or how much is needed to stay afloat.
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What is net profit?
Net profit is the amount of money a business makes after expenses, taxes, and all other costs have been deducted from total revenue. Often referred to as the 'bottom line', it represents the actual amount of profit available to a business once all costs are deducted, as it appears at the bottom of the income statement. The net profit formula is as follows:
Net Profit = Total Revenue - Total Expenses
What is the difference between gross profit and net profit?
Gross profit focuses on the value of your sales, minus the costs directly involved in making the sale. In contrast, net profit defines a final level of earnings, says Khan. It takes into account all business overheads such as salaries, rent and administrative expenses. This means net profit is a lower number than gross profit. You’ll often see the gross profit and net profit converted into a percentage and described as a margin, e.g. 'net profit margin'.
Example of gross profit
Imagine you sell your products for £10 and that item cost you £4 to make. Gross profit deducts the direct costs of making your product, known as cost of goods sold from the sale price, or total revenues. In this example, your gross profit would therefore be £10 minus £4 = £6.
Example of net profit
Net profit takes the total gross profit and deducts all your other business expenses from it, such as office rental and utility bills. Taking the example above, imagine your total gross profit was £6,000 per month and your monthly overheads are £1,000. Your net profit would be £6,000 minus £1,000 = £5,000.
Advantages of using gross profit
Gross profit offers a straightforward snapshot of profitability without getting into more complex financial details. Using gross profit as a business metric also offers several other key advantages:
Pricing Strategy Assessment
Gross profit helps businesses evaluate whether their pricing strategy is effective, ensuring that products are priced to cover production costs and generate profit.
Cost Management
It highlights areas where cost efficiency can be improved, such as reducing production costs or renegotiating contracts with suppliers to enhance profitability.
Performance Tracking
Gross profit enables businesses to track performance over time, identify trends, and make necessary adjustments to optimise future sales and profitability strategies. By comparing it to industry benchmarks, a business can also assess whether it is performing better or worse than competitors.
Disadvantages of using gross profit
A strong understanding of gross profit allows you to make quick decisions to support the growth and resilience of your business. But it doesn’t take all your overheads into account. “If a business ran solely through the management of gross profit, it might find itself in a situation where overheads escalate out of control and whilst the gross profit might look healthy, the business might be running at a loss when the result is calculated,” says Reader.
Indirect costs and the gross profit formula
The gross profit margin formula only includes the variable costs directly tied to the production of your goods or services. Wider company expenses, such as paying for the corporate office, are not included in the final metric. Instead, these expenses sometimes show on an income statement as ‘Selling, General and Administrative' costs. These can include the wages of employees such as accounting, IT and marketing as well as advertising and promotional materials. It also includes any rent, utilities or office supplies that are not directly used to create a specific product.
However, just because other indirect costs aren’t factored into the gross profit calculation doesn’t mean you shouldn’t keep a close eye on them too. These ‘costs of doing business’ affect your cash flow just as much as expenses that are directly related to products and services.
Does not facilitate relative comparison between companies
Because gross profit doesn't account for differences in company size or business models, it becomes less useful for contrasting revenue between different organisations. This is because it lacks the relative context concerning revenue or costs.
Comparative gross profit is not an indicator of financial health
Comparative gross profit, meaning gross profit compared across different business periods of quarters, does not provide an accurate picture of overall financial health. This is because it doesn't account for certain factors like operating expenses, debt and cash flow.
Key takeaways
- Gross profit shows how effectively a company might utilise resources to generate revenue. It's important for price setting and assessing profitability.
- Gross profit is calculated by subtracting the cost of goods sold (COGS) from total revenues.
- Gross profit is an absolute value, whereas gross profit margin is expressed as a percentage of revenue.
- It's important to regularly track and monitor gross profit.
- There are limitations of gross profit, particularly that it only includes the variable costs directly tied to the production and is not an indicator of overall financial health.
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