What is gross profit?
If you’re just starting to dig into the accounting metrics of your business, gross profit is easily one of the most important of those metrics to understand.
Put it simply, gross profit is the amount of money you make after subtracting the cost of goods sold.
By understanding what gross profit is and how to calculate it, you can identify where your costs may be higher than they need to (or should) be, leaving you with a small margin of profit.
That then allows you to make adjustments and maximize your entire business’s cash flow.
Let’s dive into the gross profit formula so you understand everything that goes into it and can make full use of this useful financial metric.
What is the gross profit formula?
The gross profit formula is a simple equation with big implications for your business.
The gross profit equation is as follows:
Revenue – Cost = Gross profit
Revenue refers to the amount of money you generated when a client, customer, or other consumer purchased your product or service from you for.
Cost refers to cost of goods sold (or COGS), the cost of selling your product or your service to a client or customer.
When you take the price the customer paid (sale) for your product or service and subtract the cost it took to sell it, you have gross profit.
What costs are included in calculating gross profit?
It’s important to understand that your cost of goods sold includes all costs associated with producing and selling your product or service.
That refers to both fixed and variable costs.
What that means is your cost of goods sold includes variable expenses (expenses that change frequently and depending on the product or service) such as:
- Materials
- Labor
- Shipping and processing
- Credit card processing fees
But it can also include certain fixed expenses, including:
- Payroll for employees whose jobs are associated with production quality
- Equipment depreciation
What about other fixed expenses?
Fixed expenses are where gross profit gets tricky (and where it’s generally best to leave it to an accountant).
That’s because some fixed expenses can be considered a part of your cost of goods sold while many aren’t.
These fixed costs are considered operating expenses and aren’t included in the gross profit formula:
- Lease/Rent
- Payroll of non-production-related employees
- Taxes and benefits
- Advertising
- Office expenses
- Insurance fees
Even still, some companies prefer to keep all fixed expenses out of COGS altogether.
Ultimately, that’s your choice. But a more accurate calculation would be the former where you include those fixed expenses that are relevant in the production and sale of your offering.
Why is knowing gross profit important?
Both fixed and variable expenses together are used in calculating your cost of goods sold.
For that reason, it’s important to know exactly what you’re paying for all variable and fixed expenses and how that balances out with your revenue (your sales).
Knowing your gross profit is critical because, at the end of the day, it’s what your business is “bringing home”.
All those sales you’re making aren’t truly (or fully) yours because you’re paying to produce the product or create and offer the service to your employees.
Not until you subtract all of the costs associated with that can you fully understand the health of your business in terms of profit.
The higher your profit, the more cash you have for literally anything.
That includes creating a cushion in case of an unexpected slowdown, putting money aside in anticipation of your next busy season, or investing in new products, hires, or an additional location.
How to calculate gross profit
Because gross profit may include both fixed and variable expenses, it’s a bit trickier than it at first appears to calculate gross profit.
However, nowadays accounting programs like Quickbooks help greatly in mostly automating this calculation (and the rest can be taken care of by an in-house accountant).
But if you’re just getting started and aren’t set up on an accounting program such as this yet, or rather carefully calculate your gross profit yourself, let’s go over an example to see how you’d do it.
Gross profit formula example: How to find your gross profit
J.R. owns a retail clothing store in a busy strip of downtown Dallas, Texas.
As a retail store, he doesn’t produce the clothing himself. Rather, he purchases clothing from various wholesale brands and then sells them at a markup.
Let’s say the average T-shirt at his location costs $10 to purchase. And it costs him another $5 in averaged expenses to sell each T-shirt (everything between displaying and ultimately selling his clothing).
That brings his COGS to $15 for every T-shirt. With an average price of $25 per T-shirt, his gross profit is $10:
$25 REVENUE – $15 COGS = $10 GROSS PROFIT
It’s important at this point to keep in mind that that (average) $10 he takes home from each T-shirt sale isn’t all his.
Gross profit doesn’t include operating expenses such as advertising and rent, as mentioned earlier.
Only once you’ve calculated those operating expenses and subtracted them from your gross profit do you have your net profit.
How to calculate gross profit margin
Now that you know how to find your gross profit, that leads us to another important financial metric: your gross profit margin.
What is your gross profit margin?
Gross profit margin is the percent difference between your revenue and your gross profit and it serves as a valuable way of determining your business’ profitability.
The gross profit margin calculation is:
Gross profit / Revenue = Gross profit margin
So, going back to our example, J.R. would be looking pretty good:
$10 Gross profit / $25 Revenue = 40% Gross profit margin
Why knowing your gross profit margin is important
Gross profit tells you how much money your business is bringing in, but that number can be deceiving.
It is possible for your gross profit to increase from one quarter or year to the next, particularly during a period of growth, while technically you became less efficient.
Let’s say your operating expenses increased in sync with your level of growth but your gross profit margin went down.
While you might be bringing in more money, you’d actually be in worse shape and could even have a hard time paying those operating expenses if your profit margin drops low enough.
By knowing your profit margin, you know much more than how much money your business is bringing in. You know how effectively your business produces and sells its goods and/or services.
Learn more about your profit & loss
Understanding gross profit and how to calculate it is important.
When reviewing your profit & loss report, the more you know, the easier it becomes to spot trends and identify areas of concern long before they become a real issue.
By understanding your gross profit, you’re now able to spot more of those clues and better identify important financial patterns in your business.
