Gross profit is a key measure of your financial performance for the year, helping you understand how the cost of producing goods or services translates into revenue. This guide shows you how to calculate gross profit, explains its importance, and looks at the key benefits of this crucial financial metric.
What is gross profit?
Gross profit is the accounting term for the income your business generates after subtracting cost of goods sold (COGS) or cost of sales – the direct costs associated with producing and selling goods or services.
Why is gross profit important and what does it tell you?
Gross profit is important as a key figure on your income statement and as a way to gain insight into how efficiently your business turns labour and materials into goods or services. If you know how much gross profit you're making each year in comparison to the cost of production or services, you can tweak costs and make changes to increase profitability.
How to calculate gross profit
You calculate gross profit by subtracting the cost of goods sold (COGS) or cost of sales from your revenue for the year. Revenue is defined as income generated from sales, while COGS includes all the costs involved with production and delivery – including raw materials, manufacturing costs and labour. COGS doesn't include operating costs like rent, mortgage payments, equipment, insurance or taxes.
Gross profit formula
The gross profit formula is:
Revenue - COGS = Gross Profit
Revenue
Revenue is the total income your business produces through day-to-day operations, before subtracting any costs. It's sometimes called a ‘top line' metric because it sits at the top of your income statement. While revenue gives you an indication of how your sales are performing, it doesn't tell you anything about profitability.
Cost of goods sold (COGS)
COGS – sometimes called COS or cost of sales – is a term for the direct costs of making goods or providing services. Unlike fixed costs, which stay the same regardless of the number of goods sold, COGS are variables that rise and fall with your production or service volumes. For example, the more product you manufacture, the more you'll spend on raw materials and labour.
Advantages of using gross profit
The advantages of using gross profit as a measure of profitability and performance include:
Easy to calculate
Calculating gross profit (the difference between sales revenue and the cost of goods sold) is a straightforward measure of profitability for your goods and services, before factoring in operating expenses and other costs. It’s a simple way to see how effectively your business uses materials and labour.
Provides strategic insights
Gross profit can be an effective way to analyse and compare profitability for specific products or business areas. This can help you identify which products to focus on and how to price them to maintain target profit margins.
Identifies cost reduction opportunities
By focusing attention on the direct cost of selling a product or providing a service, businesses can look for ways to reduce their cost of goods sold and increase their gross profit.
Enables comparisons with competitors
Since gross profit concentrates on the costs directly related to producing goods or services, gross profit margins can help you compare your business to others in your sector, regardless of their size or structure.
Disadvantages of using gross profit
The main disadvantage of gross profit is that it's a blunt measure of profitability – it doesn't tell you much about the why or how of your business performance.
Gross profit tells you how much money you're making in comparison to COGS, but doesn't tell you about your overall financial performance. For example, you may have high gross profit margins but still record net losses if your operating expenses are too high.
Gross profit vs gross profit margin
The key difference between gross profit and gross profit margin is the way they're expressed.
Gross profit is the dollar amount left over after subtracting the cost of sales from revenue.
Gross profit margin shows the percentage of profit as compared to revenue. While gross profit measures past performance, gross profit margin can help you set prices and forecast future profitability as well.
Gross profit vs net income
Gross profit and net income are quite different:
Gross profit measures your revenue minus the cost of sales. It's a metric of how efficiently your business turns labour and raw materials into profits.
Net income shows your profits after all your expenses have been deducted – including rent, mortgage payments, equipment, tax, insurance and other fixed operational costs. Because it accounts for these costs, net income is a clearer representation of your real-world profitability as a business. Net income is known as your “bottom line” and shows how much actual profit you have.
Gross profit FAQs
Does gross profit include tax?
No, gross profit doesn't include tax. The gross profit calculation only includes the direct costs involved with making a product or providing a service (COGS), not other operational expenses.
How do you calculate gross profit margin?
The standard calculation for gross profit margin is:
(Gross Profit ÷ Revenue) X 100 = Gross Profit Margin
What is considered a good gross profit margin?
There’s no single profit margin that’s ‘good’ for all businesses, but for most, a gross profit margin of over 50% indicates financial health – although some businesses pull in margins of up to 90%. If your margin is under 30%, it could be a sign of issues, particularly if your business has high fixed costs.
Track and measure with MYOB
Gross profit is a key performance indicator that can help you understand how your expenses stack up against revenue. It starts with close tracking of your costs and revenue. MYOB's accounting software is designed to help small businesses keep track of day-to-day incomings and outgoings, making it easy to calculate gross profit and other key metrics and assess your ongoing performance. Get started with MYOB now.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.