Gross means the total amount. Gross profit is the company’s earnings from the sale of goods and services.
When you calculate it, you take the total revenue from sales, minus the costs related to producing the goods and services. These costs are commonly called variable costs.
The gross profit is included in the income statement and shows how your company is performing financially.
Note that operating profit is a different beast altogether: it shows income after operating costs—both variable and fixed costs—have been subtracted.
How to calculate gross profit
To calculate the gross profit, you first take the sales revenue, then subtract the cost of producing goods and services, such as materials, labor costs, and shipping. Note that you don’t include fixed costs in this calculation.
Let’s say you make $25 000 from selling goods and services. The cost to procure those goods and services was $5 000. The gross profit would be $25 000 – $5 000 = $20 000.
To convert it to a percentage, you can multiply the number by 100 and divide it by the sales revenue: ($20 000 x 100) / $25 000 = 80%.
If you want to know if you’re operating with a profit or loss, you also have to work out your break-even point.
Why is it important?
Gross profit and net profit both matter. Gross profit is revenue minus the cost of producing goods and services. For example, if you earn $100 000 in a year, and spend $30 000 producing goods and services, then you’ll have a gross profit of $70 000.
The net profit is gross profit minus all other fixed costs. If you have a gross profit of $70 000, and spend $20 000 on renting office spaces, insuring your company, utilities and so on, then you’ll have a net profit of $50 000.
Gross profit is important because you have to retain enough money to cover all your fixed costs. If you have a very small gross profit, you might need to review your pricing strategy, improve or adapt your products and services, or try to lower your production costs.
The tax authorities also often use the gross profit averages of an industry to assess whether companies are likely to have undeclared sales that they haven’t reported in their general ledger, in an effort to pay less corporate tax.