What is gross profit?
Gross profit is a company’s total sales after deducting the costs associated with selling its products and/or services. It’s a company’s total profit before subtracting it’s operating expenses, interest and tax payments.
Synonymous terms include gross margin, gross income and sales profit.
How to calculate gross profit
The formula for gross profit is: Gross profit = Total sales – Cost of goods sold
Total sales: Also known as revenue, this is is what a company earns for selling its products and services.
Cost of goods sold: This figure is made up of the direct, variable costs associated with making and selling those products and services. Variable costs are costs that change based on the amount of products or services produced and sold. Examples of these include:
Materials and purchase price of goods
Wages for workers who make the products or provide the services (hourly based employees)
Commissions of sales staff
Freight and shipping charges
Utility costs related to the products
Why is gross profit important?
Gross profit shows the overall financial success of products or services, as it reflects a company’s income prior to overhead expenses.
It can also be used to calculate the gross profit margin, which is essentially the percentage version of gross profit. The gross profit margin is used for comparison purposes, such as measuring a company’s production efficiency over time or comparing to the industry average to measure performance amongst the market.
Here’s how to calculate gross profit margin:
Gross Profit Margin (%) = (Gross Profit / Total Sales) x 100
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The difference between gross profit and net profit
Unlike gross profit, net profit takes into account the deduction of a company’s operating expenses - such as payroll, rent and repairs - as well as interest payments and taxes. Net profit is also known as net income.
Furthermore, a business could have a high gross profit and a much lower net profit, which means that it might not be deemed as financially successful after all. If the operating expenses are higher than the gross profit, the net profit will be negative. In other words, it’d be a ‘net loss.’
Here’s an example of the difference between gross profit and net profit of a company’s Income Statement:
Net Sales: $40,000
Cost of Goods Sold: $20,000
Gross Profit: $20,000
Operating Expenses: $5,000
Earnings Before Interest & Taxes: $15,000
Interest Expense: $1,000
Net Profit: 10,000
How to increase your gross profit
To increase your company’s gross profit when starting or scaling your business, you’ll want to find ways to increase your revenue and lower your production costs. You can increase revenue by, for example, adding a new sales channel, and you can decrease the cost of good sold by finding less expensive ways to make your product.
Understanding what gross profit is and how it can be increases is an essential part of your bookkeeping and business accounting planning.