April 13, 2023 |5 min read
Understanding your gross profit should help you see how well your business is performing and highlight which aspects of your business are the most valuable or have the most potential, so you can prioritize and expand them. When you know how much profit your business generates and which areas earn the most revenue, you should be able to make confident leadership decisions that are backed by tangible numbers and help you adapt your business to industry or market changes.
What is gross profit?
Gross profit—also known as sales profit or gross income—is measured by subtracting the cost of goods sold (COGS) from the revenue made from sales. It’s an easy formula that should help you measure the value your goods and services bring to your business. Gross profit typically only includes variable costs—such as hourly wages or materials—that fluctuate with demand. It doesn’t include fixed costs, like lease payments, that are stable regardless of how many goods and services you produce. Investors and business owners evaluate a company’s gross profit in order to understand the price variation a business is able to charge.
Formula for gross profit
Gross profit measures the money your goods or services earned after subtracting the total costs to produce and sell them. The formula to calculate gross profit is the total revenue minus the cost of goods sold.
Total Revenue - Total COGS = Gross Profit
Cost of goods sold
COGS includes only variable costs associated with the production of a good or service. Variable costs are those that change as the production output changes. They may include:
- Materials and parts
- Labor costs for staff directly involved in production
- Packaging and shipping costs
- Equipment operation costs (which may include utilities)
- Processing fees for consumer purchases
- Depreciation of equipment
- Sales commissions
COGS does not usually include fixed costs, such as marketing budgets, labor unrelated to manufacturing (like executive pay), insurance, software and other subscriptions, equipment leases and property taxes.
Revenue
Revenue refers to the total amount of money earned from the sale of your business’s products or services. Usually, this income amount is not adjusted to account for expenses like business overhead, taxes or interest. It only reflects the money earned from sales.
Gross profit calculation example
Imagine that you own a doughnut shop. Your variable expenses include raw materials to make the dough, icing and coffee drinks; paper goods, cups and lids; toppings and add-ons; wages for your team; and processing fees for customer purchases. You want to calculate the gross profit for your entire business (not just the coffee drinks), so you total your revenue and variable costs for the first quarter of the year.
Your spreadsheet to calculate the gross profit should look something like this:
In this example, the total gross profit for the first quarter of 2022 is $79,225.
Why is gross profit important?
Calculating gross profit is important because it gives you a clear understanding of your company’s financial health. Beyond demonstrating how much profit your offerings generate for your business, gross profit calculations can shed light on the efficient use of labor and company resources. A high gross profit typically indicates that you have optimized your process and material choices to deliver profitable items or services quickly and affordably.
At the micro level, gross profit calculations can help you decide if a particular product or offering is generating revenue. If a specific product has high material and labor costs with a small gross profit, you may need to optimize the production process, reevaluate supplier contracts or consider removing the item from your product line. Additionally, estimations can inform more significant business decisions like steps to take during an economic downturn or where to reinvest profits after a successful quarter.
What is a good gross profit?
What’s considered a good gross profit typically varies depending on factors like company size and industry. Most businesses calculate their gross profit margin to get a better sense of their business performance. Your gross profit margin calculates the percentage of revenue that is profit, and it is helpful when comparing to other businesses in the industry.
To calculate your gross profit margin, divide your gross profit by your total revenue and multiply it by 100. For the doughnut shop example above, the gross profit margin formula would look like this:
[$79,225] ÷ [$209,060] X 100 = 37.89
[Gross Profit] ÷ [Total Revenue] X 100 = [Gross Profit Margin]
The doughnut shop’s gross profit margin would be 38%. In some industries, anything above 20% is good, but in high-end industries like fine jewelry, a good gross profit margin may be above 50%. Larger companies also tend to have higher profit margin expectations than small businesses do.
Gross profit vs. gross profit margin
Although similar in name, gross profit and gross profit margin are not the same and should not be used interchangeably. Gross profit represents a fixed currency amount, while the profit margin is identified as a percentage or ratio.
The bottom line
Your gross profit should help inform important decisions in your business and may be key to its success. When you understand which goods are most profitable, which services are straining your earnings and how your business is performing, you’ll be more empowered to make strategic decisions to grow your business, weather hard times or develop a plan to improve performance.
