Gross profit is an important area of a company’s income statement that can provide crucial insights into how effectively you are using your resources to make and sell your products or services.
“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.
Here’s a look at what gross profit is, how to calculate it and how you can use it for growth.
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.
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How is it calculated?
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
Gross profit can also be understood as a percentage of your company’s revenue using the gross profit margin formula. But for now, let’s look at both of the elements in the gross profit formula in more detail.
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
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.
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 offered, says Reader.
Gross profit can support small business owners in understanding what price to charge customers, says Khan. It can show you if the purchase price of goods or services directly linked to sales is low enough to generate a profit. If not, you can take measures to increase profit, such as by driving greater efficiencies in production, negotiating lower prices with your suppliers or revising the price you charge customers. Gross profit can also be used to look at the year-on-year performance of specific product sales, which can help you identify trends and patterns that can inform future sales, she says.
Christine Nicholson, a business mentor, sums up the value of gross profit. “Without knowing it, you have no idea what your break even is or how much you need to sell to keep afloat.”
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.
Limitations 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 end 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.
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