Gross Profit: Formula, How To Calculate & Its Importance To Businesses

Gross profit (GP) is a great tool to manage both sales revenue and cost of goods sold (COGS). When you’re running a business, it’s important to keep an eye on gross profit to make sure your organisation is on track for profitability and success. 

But how is gross profit calculated? In this guide, we’ll explain what gross profit is and provide a gross profitability formula. We’ll also provide strategies to help your business reduce costs and increase company profits. 

Keep reading to find out how to find gross profit, or use the list below to jump ahead: 

• What is Gross Profit?
• Why is it Important to Calculate Your Gross Profit and What Does it Tell You?
• Gross Profit Formula
• Example of How to Calculate Gross Profit
• Advantages of Using Gross Profit
• Disadvantages of Using Gross Profit
• Gross Profit vs Gross Margin
• Gross Profit vs Net Income
• Achieve Profitability With the Gross Profit Formula
• Using Gross Profit Calculations in Your Business Planning
• Gross Profit FAQs

What is Gross Profit?

What is a gross profit and why does it matter? 

To define gross profit, it’s important to first understand what’s meant by the terms ‘sales revenue’ and ‘cost of goods sold’:

• Sales revenue: This refers to the total earnings from goods or services sold.
• Cost of goods sold (COGS): This includes all the direct costs of production and sales.  

Gross profit is the amount a business earns after subtracting the cost of goods sold (COGS) from total sales revenue. It reflects the profitability of core operations before accounting for operating expenses, taxes, and other costs.

Please note: gross profit differs from net income, which factors in operating expenses. Similarly, sales revenue is not the same as total revenue, which includes non-operating income. For instance, if a manufacturer sells equipment at a profit, that profit counts as revenue but is not included in the gross profit calculation.

Why is it Important to Calculate Your Gross Profit and What Does it Tell You?

Calculating gross profit is crucial because it shows how efficiently your business produces and sells its goods or services. It helps assess profitability by revealing the difference between sales revenue and the cost of goods sold (COGS). 

Sales revenue and the COGS are two of the biggest balances in the income statement. If you can make changes to either balance, you can increase profitability. Operating expenses may be harder to reduce since many of the costs are fixed.

A healthy gross profit indicates strong pricing strategies and cost management, while a declining margin may signal rising costs or pricing issues. Businesses use this metric to make informed decisions about pricing, budgeting, and overall financial health.

Gross Profit Formula

Understanding gross profit helps managers analyse financial performance and improve business outcomes. But how do you calculate gross profit?

Here’s a simple gross profit equation:

Sales Revenue - COGS = Gross Profit 

Sales Revenue

Sales revenue is the total income a business earns from selling its goods or services before any expenses are deducted. It is calculated by multiplying the number of units sold by the selling price per unit. 

Please note: sales revenue differs from total revenue, which may include other income sources like interest or asset sales.

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) refers to the direct costs of producing or purchasing the goods a business sells. This includes expenses like raw materials, manufacturing, labor, and shipping costs. 

COGS does not include indirect expenses such as marketing or administrative costs.

Example of How to Calculate Gross Profit

To understand the gross profit formula, meet Sally, the owner of Outdoor Manufacturing. Sally’s business manufactures hiking boots, and her firm just completed its first year of operations.

The sales component of the formula is straightforward (selling price multiplied by the number of boots sold). Outdoor Manufacturing sold $520,000 worth of boots in 2020. The firm’s cost of sales component is more complex, however. What expenses are included in the COGS balance?

The COGS balance includes both direct costs and indirect costs (overhead). Managers need to analyse the costs and determine if they are direct or indirect. In addition, companies must label expenses as fixed or variable costs.

Direct vs Indirect Costs

Direct costs are directly related to producing a product or delivering a service. The most common direct costs are raw materials and labour costs.

Indirect costs, on the other hand, cannot be traced to a specific product or service. Instead, indirect costs are allocated to production. Most managers use the term “overhead” rather than “indirect costs”.

Outdoor Manufacturing’s COGS balance includes both direct and indirect costs.

Direct Materials

Outdoor Manufacturing purchases leather material to manufacture hiking boots, and each boot requires about 1.82 square metres of leather. Both the cost of the leather and the amount of material required can be directly traced to each boot. Outdoor Manufacturing knows how much material is required to produce a 1,000 production run of boots.

Direct Labour

Hiking boot production also requires labour costs. Outdoor Manufacturing pays workers to operate cutting and sewing machines, and to stitch some portions of each boot by hand.

Based on industry experience, the management knows how many hours of labour costs are required to produce a boot. The hours multiplied by the hourly pay rate equals the direct labour costs per boot. Outdoor Manufacturing knows the direct labour costs required to produce 1,000 boots.

The 2020 income statement reports that Outdoor Manufacturing incurred $170,000 in direct material costs and $250,000 in direct labour costs.

Allocation of Overhead

Outdoor Manufacturing’s overhead costs are posted to the operating expenses. The only way to recover the overhead costs is to sell an item to a customer, so each dollar of overhead must be allocated to a product or service.

Overhead costs are allocated based on a level of activity. Here are some common examples:

Tradespeople (like carpenters, plumbers and tree service firms) incur travel costs, as they travel to each client’s location. The more kilometres driven, the more repair and maintenance costs incurred on the vehicles. A plumber may allocate overhead costs based on the kilometres driven. If serving a customer requires driving 30 kilometres, the plumber adds 10 cents per kilometre to cover the vehicle repair and maintenance costs.

Overhead costs are frequently allocated using machine hours incurred or labour hours required, or simply using the number of units produced.

Fixed Costs vs Variable Costs

Managers need to know why a particular cost is being incurred. One way to understand costs is to determine if the expense is fixed or variable.

Direct costs, such as materials and labour, are typically costs that vary with production. However, if a customer contract requires you to hire an outside firm to assess quality control, that one-time cost may be considered a fixed direct cost.

The cost paid to an office security company is a fixed overhead cost. You need the firm to protect the company’s assets, regardless of how much you produce or sell. On the other hand, the hourly rate paid to repair the company’s machinery is a variable overhead cost.

Inventoriable costs are not immediately assigned to the COGS account. 

Inventoriable Costs

Inventoriable costs are defined as all costs to prepare an inventory item for sale. This balance includes the amount paid for the inventory item and shipping costs. If a retailer must build shelving or incur other costs to display the inventory, the expenses are inventoriable costs.

The cost to train people to use a product is also included in this category. The cost to train employees to use IT is a good example.

When the inventory item is sold, the inventoriable costs are reclassified to the COGS account. A retailer may have thousands or even millions of dollars in inventoriable costs that are not yet expensed.

Advantages of Using Gross Profit

There are several advantages to monitoring gross profit, including:

• Measures profitability: Gross profit helps businesses understand how efficiently they produce and sell goods by showing the difference between revenue and production costs.
• Identifies cost efficiency: By tracking gross profit, businesses can pinpoint areas where production costs can be reduced without affecting product quality.
• Supports pricing decisions: A strong gross profit margin ensures that pricing strategies cover costs and generate sustainable earnings.
• Evaluates business performance: Comparing gross profit over time helps businesses assess growth, efficiency, and financial health.
• Aids in forecasting and budgeting: Understanding gross profit trends allows businesses to plan for future expenses, investments, and financial goals.
• Helps attract investors and lenders: A healthy gross profit margin signals financial stability, making it easier to secure funding or investment.

Disadvantages of Using Gross Profit

Using gross profit as a measurement of profitability and performance can also come with disadvantages. These may include:

• Does not account for operating expenses: Gross profit only considers production costs, not other expenses like rent, utilities, or marketing, which are crucial for overall profitability.
• Ignores non-direct costs: It doesn't reflect overhead costs, such as administrative salaries or office supplies, which can significantly impact the bottom line.
• Can be misleading for service-based businesses: Gross profit may not provide a clear picture for service-based industries where production costs are minimal compared to the cost of labour or expertise.
• Excludes depreciation and interest costs: Gross profit doesn’t factor in long-term costs like depreciation or interest on loans, which can affect a company’s financial health.
• May not reflect true profitability: A high gross profit can be misleading if a business is overspending on operating or non-operating expenses.
• Does not consider tax impact: Gross profit ignores taxes, which can heavily influence the actual earnings of a business.

Gross Profit vs Gross Margin

Gross margin is expressed as a percentage, while gross profit is stated as a dollar amount. 

Gross margin is defined by this formula:

(Total revenue – cost of goods sold) / (total revenue)

The 2020 gross margin for Outdoor Manufacturing is:

($520,000 revenue – $420,000 cost of goods sold) / ($520,000 revenue) = 19.2%

For every dollar of sales, Outdoor Manufacturing generates about 19 cents of gross margin. The gross profit formula helps you identify cost-saving opportunities on a per product basis.

Gross Profit vs Net Income

Net income is the total profit of a business after all expenses, taxes, interest, and costs have been subtracted, while gross profit only considers the direct costs of producing goods or services.

Net income is calculated as:

Gross profit – operating expenses – taxes – interest = Net Income

Outdoor Manufacturing has a gross profit of $200,000, operating expenses of $120,000, taxes of $30,000, and interest of $10,000. Therefore, the net income for this business is:

$200,000 – $120,000 – $30,000 – $10,000 = $40,000

Whereas gross profit reflects the basic profitability of a company’s core activities, net income provides a more comprehensive view of overall financial health, factoring in all business expenses.

Achieve Profitability With the Gross Profit Formula

In this section, we’ll explore how your business can leverage the gross profit formula to enhance profitability by identifying areas for cost reduction and improving pricing strategies.

Increasing Revenue

Businesses can increase revenue by raising prices, but price increases can be difficult in industries that face a high level of competition. The ability to purchase products and services online also puts downward pressure on prices.

There are other strategies to increase revenue, but the most effective way is to increase sales to your existing customer base. You can also increase revenue by improving your marketing outcomes. Use promotions, rewards, and testimonials to promote your products, and survey your customers to find out what products they want.

The other strategy to increase gross profit is to reduce costs.

Reduce Material Costs

You can reduce material costs by negotiating a lower price with your suppliers. If you’re a large customer who buys materials every month, you may be able to negotiate a lower price based on your purchase volume.

The material costs you incur are driven by cost and by usage. Analyse your production and take steps to avoid wasting material.

Take a close look at your labour costs, and see if you can find ways to lower spending.

Decreasing Labour Costs

Just as with material costs, labour costs are a function of the hourly rate paid and the number of hours worked.

The hourly rate you pay is closely tied to current economic conditions and the rate of unemployment. If the economy is growing, you may need to pay a higher hourly rate of pay to hire qualified workers. The opposite is true in a slowing economy.

Invest in training so that employees can work efficiently. Well-trained workers can get more done in less time, and they make fewer mistakes.

When you create an annual budget, include gross profit calculations to forecast the company’s profit.

Using Gross Profit Calculations in Your Business Planning

When you build a budget using gross profit, you can reduce costs and increase revenue in the planning process.

We recommend using accounting software that can easily calculate GP and other important metrics. This makes it easy to compare your firm’s gross profit to other companies in your industry. Finally, put in the time to make improvements that lower costs and increase revenue.

Be proactive and make improvements sooner, rather than later. Your business results will improve, and your firm will increase in value.