Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Costs deducted typically include the cost of materials and the direct costs associated with production, such as the cost of labor. Direct costs do not include indirect expenses, such as distribution costs and sales force costs.
In financial accounting, gross profit or sales profit is the difference between revenue and the cost of making a product or providing a service, before deducting overheads, payroll, taxation, and interest payments.
Gross profit will appear on a company’s income statement and can be calculated by subtracting cost of goods sold (COGS) from revenue (sales). The figure is commonly used to calculate the gross margin.
Importance of Gross Profit
Gross profit measures how much money you earned on sales minus the costs associated with those sales.
It’s a key metric for evaluating the performance of your business, and it is usually one of the first numbers reported on a company’s income statement. In fact, for many companies, gross profit is the largest contributor to operating income.
Business owners often focus on top-line revenue, or total sales, believing that this is the best measure of the health of their business. However, it’s important to keep an eye on your gross profit figures. Since it is the money left over after all direct costs have been covered, this figure gives a much better indication of the financial health of a business than revenue alone.
How Gross Profit Margin Is Calculated
You can calculate the gross profit by subtracting COGS from revenue:
Revenue – Cost of Goods Sold (COGS) = Gross Profit
COGS includes all direct costs associated with producing your product or service, like labor and raw materials.
It also includes manufacturing overhead, which cannot be directly tied to production but are necessary to do business.
Gross Profit Percentage
Gross profit percentage is a measure of sales profitability. It reflects the amount of money remaining from sales after accounting for the cost of goods sold or COGS, sometimes called the cost of sales. You might also think of it as the margin on your products or services.
Gross profit percentage is calculated by dividing gross profit by net sales.
Gross profit percentage can be useful for comparing your business to industry averages and assessing how changes in your business such as raising prices might affect profitability. The higher the gross profit percentage, the more profitable your products are.
Gross Profit Example
Now let’s look at an example of gross profit. Say a company produces T-shirts and sells them for $20 each. It costs the company $5 to produce each T-shirt. Therefore, the variable cost (or cost of goods sold) is $5 each. The fixed cost is the amount it costs to keep the business running: accounting fees, rent and utilities, employee salaries, shipping and so on.
The gross profit margin can be calculated as follows:
Gross Profit = Total Revenue – Variable Cost = $20 – $5 = $15
Gross Profit Margin = Gross Profit / Revenue = 15 / 20 = 0.75
Let’s say that this company sold 100,000 shirts over the last year. That would mean it had revenue of 100,000 x 20 = $2 million and gross profit of 100,000 x 15 = $1.5 million. The gross profit margin (gross profit divided by revenue) would be 1,500,000 / 2,000,000 = 0.75 or 75%.