What is gross profit and how to calculate it

Gross profit should be an easy figure to calculate but its definition can give people a problem.

However, if you want to get the rest of your figures right, this one comes first and it’s a crucial building block for you.

Gross profit is one of those great figures that gives you a quick snapshot of how your business is doing.

It’s a rough guide, if you like, on your company’s performance and status, and it’s very useful.

However, arriving at the figure can cause some confusion. It also doesn’t give the overall picture of how your company is performing, so some caution needs to be observed.

Getting a gross profit figure is, on the basic level, very easy to calculate.

Here’s what we’ll cover in this article

Definition of gross profit

The definition of gross profit is that it is the amount of money left minus the cost of goods sold (COGS).

It also includes costs associated with manufacture of products to sell, over a certain time, such as:

• monthly
• quarterly
• yearly

This is an accurate indicator of profit or loss during the particular period of time. Production and manufacturing costs have been removed, showing the remaining funds available.

A gross profit calculation is needed to get to the net profit amount where further deductions are made to take into account tax, and other outgoings.

How gross profit is calculated (gross profit formula)

This gross profit formula shows you how to calculate gross profit:

Total revenue from sales – Cost of goods and services sold = Gross profit

Importance of gross profit

Gross profit is important to calculate your profit margin as it provides a snapshot of your production costs.

It’s the first part of a profit and loss statement needed to calculate the overall financial health of your business.

If your profit margin is low, it could indicate problems.

For instance, you might be paying too much for certain parts of your production chain, or not charging customers enough for the products after a rise in cost of goods for manufacture.

Gross profit can fluctuate according to external sources like inflation, supply-chain issues, and shifts in the global economy.

It’s important to understand the economic context of a low profit margin and be agile enough to weather these problems over time.

If your profit margin is high, this could provide evidence to your leadership team and potential investors that you are running a healthy business.

However, in recent years and since the pandemic, criticism has been heaped onto businesses that pass on external factor costs to the customers.

Praise has been given to those businesses that absorb the extra costs. Their products remain affordable amid a global cost-of-living crisis.

As a business owner, you will have to decide what is important to you, your business, and your customers.

They may be willing to pay a bit more for a quality product, but not for items they can get cheaper elsewhere.

Issues when working out gross profit

The confusion can first arrive because different businesses call their sales various things.

The main three being:

• sales
• turnover
• revenue

For small businesses, the best term to use is “sales”–referring what your company actually sells.

The word “turnover” is often used by larger companies because it might incorporate sales of products. It may include other things such as recurring income (items billed every month), which are sales of course but can be defined in a slightly different way.

“Revenue” is a term more commonly used in the US.

It’s the same as “sales”, although professional firms are bigger users of this term as they believe it better reflects their business than just the term “sales”.

However, whatever term you use, it comes down to what your company does to generate its cash.

It’s the money you take, minus the money it costs to get the things that make you your money.

If you’re selling cans of cola, for example, your gross profit is the amount of money you take from your customers minus the amount it cost to buy the cans.

Thus, if the retail price is $1 and you buy the cans from a wholesaler at $0.50, then your gross profit is $0.50.

Net profit

Now, don’t forget that gross profit can also be a loss.

So, if you’re having a bad day and you’ve had to sell your cans of cola for $0.50, the same as you bought them for, then you are at a net position.

If you had to sell them for $0.40, you are looking at a loss of $0.10 per can.

Not a good place to be.

Ok so far? But the reason this gross profit figure is so important is that from here, your other figures are built.

If you want to figure out net profits (arguably the key indicator of a company’s performance), then you take sales, minus the direct costs (as above).

From that figure, take away indirect costs (everything else that is a cost to your business–so rent, staff costs, postage, etc).

So, taking the number of cans of cola you sell in a year, take away from that the cost of those cans of cola from the wholesaler.

Then take from that the other costs that have allowed you to sell the cola in the first place (rent of your shop, utilities, transport, etc).

Read more: What is net profit?

Get your calculations right

The thing to remember is that gross profit is sales minus direct costs, not sales minus every cost.

Keep that in mind and you will be able to come to a gross profit figure every time.

Remember, gross profit is your first calculation.

You need to get that calculation right, otherwise your profit and loss account will not work. You will not be getting the correct information about your business.

For example, if you are selling cans of beer.

It will be the cost of making those cans of beer, so that is a direct cost. So, you would have your total sales less your direct costs equals your gross profit.

This gross profit figure is really important. You deduct your overheads to discover your net profit figure.

Read more: How to calculate profit

Final thoughts

Calculating gross profit doesn’t have to be complicated.

Follow the steps in this article and you’ll gain useful clarity over your business financial strength.