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, wage 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 is a more important number than net profit, since it also includes the cost of producing goods and services. This helps you assess how well your gods and services are performing, whether you need to increase your prices, and whether you need to reduce variable costs.
The tax authorities also often use the average for 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.