How to Calculate Gross Profit? Explore Formula and Example

What Is Gross Profit?

Gross profit, also referred to as gross sales or gross income, tells about the profit that a business gains after deducting the cost of goods sold from its revenue. In simple terms, it is an output of subtracting the cost of goods sold by a company from its generated revenue. The cost of goods sold reflects the expenditure which is directly linked with producing and selling goods and services.

A high gross profit means the company’s expenditure is less than revenue. A low gross profit margin means the expenditure of a company is higher than revenue. Companies aim for high gross margins, which indicate they are retaining more capital for each dollar of sales.

Key Points

• The other name of gross profit is gross income.
• It also includes variable costs that vary with the production level. However, it excludes insurance, administrative expenses, and fixed costs.
• Gross profit measures the company’s controllable metric as compared to net profit.
• Companies can utilize gross profit to focus on product performance and also follow strategies for cost control.

What Is the Gross Profit Formula?

In calculating gross profit, two crucial factors – cost of goods sold and revenue. The formula will be as follows:

Gross Profit = Revenue – Cost of Goods Sold

Here,

Cost of Goods Sold – It is a direct cost which is involved in producing the goods (material cost included). In case the company is selling service, its COGS will be replaced by service cost. It does not cover the expenditure related to administration, advertising, and sales labor.

Revenue – The total amount that the company generates from sales for a particular period.

How to Calculate Gross Profit?

Subtraction of COGS from the net revenue is a calculation of gross profit. Every industry type has a different gross profit. Here, we assume one example to explain gross profit calculation.

Suppose the company ABC generates revenue of $600,000 annually. The labor expenditure is $300,000, and the material cost is $100,000, so COGS is $400,000.

Now, according to the gross profit formula, the gross profit will be as follows –
Revenue – COGS

= $600,000 – $400,000
=$200,000

So, the manufacturing company ABC has a gross profit of $200,000.

For gross profit margin formula, we need to consider the following gross profit equation:

Gross Profit Margin = Revenue – Cost of Goods Sold/ Revenue * 100

= (($600,000 – $400,000)/$600,000) x 100

= $200,000/$600,000 x 100

=0.33 x 100

= 33%

The company has a net profit margin of 33%.

Now, considering the administrative cost is $45,000 and salary $24,000. However, these will be excluded from calculating gross profit.

The above example explains how to find gross profit. Here’s how you can calculate the profit margin.

What to Include in Gross Profit?

Only revenue and cost of goods sold are covered in the gross profit calculation. Salary and administrative costs are excluded from gross profit. They are not needed in gross profit and are only needed during the net profit calculation. Moreover, gross profit majorly focuses on the mentioned variable costs which change with the production level.

• Shipping
• Direct labor costs
• Sales staff commission
• Material
• Equipment
• Credit card fee

The net profit calculation covers fixed costs like salary and administrative costs along with the Cost of Goods Sold and revenue. Net profit also covers all other expenses required to run a business.

Gross Profit Vs. Gross Profit Margin

Gross profit margin and gross profit are useful in profit measurement. However, both are different terms in the following points.

How to Refine Gross Profit?

When you know how to calculate gross profit, you must also be aware of the methods to improve it. Many business professionals are curious to know about it and the following factors are the right answer.

Inventory Management System

If your inventory system has a product that is out for a long time, it can affect your profit. So keep checking your inventory and ensure no product gets stuck in inventory from production to sale.

Reducing Operating Costs

Knowing the right thing to improve gross profit needs to look at everything. Perform an audit and identify those areas wherever it is possible to cut costs in the operation process.

Do Competitive Research

Gross profit margin is useful for comparing production efficiency with competitors. In case your competitors sell the same product at the same cost but keep the production cost low, they will have a higher gross profit.

Review the Pricing Strategy

You can perform sales and promotions occasionally. You must make the cost of existing products high to increase revenue.

Increasing Customer Retention

Customer retention is also important for any business. A happy and satisfied customer also contributes to enhancing the profit margin.

Developing Sales Strategies

Proper strategies for pricing and promoting products are also crucial for improving revenues. It is also important to check the strategies of current sales and implement improvements where applicable.

Why Is Gross Profit So Valuable?

Business professionals must consider gross profit as an important benchmark. It lets them understand how well their company is doing while considering production costs and generating profit. A high gross profit indicates that a company is performing well, with expenditures and revenue well balanced. A low gross profit means a company has higher manufacturing costs than revenue.

Gross profit helps analyze business growth. Also, It is also useful for making the right decision for the aim of a company’s growth. For example, if a specific product of a manufacturing company has a high production cost with low gross profit, the business can make a specific decision on optimizing the production process.

Gross profit is helpful in determining a company’s efficiency. A high gross profit means a company’s efficiency is good while a low gross profit means there is inefficiency.

Net Profit vs Gross Profit

Net profit and gross profit both measure the profitability of the company. However, there is a difference in terms of cost considered in their respective calculations.

Subtracting the cost of goods sold (COGS) from the company’s revenue leads to gross profit calculation. Net profit is a net income, calculated after diminishing all revenues and expenses. This also covers operating expenses and production cost.

What Are the Restrictions of Gross Profit?

Gross profit is crucial for financial actions but still, it has some drawbacks. Gross profit does not include utilities, salary, and rent like operating expenses. This does not provide a clear and actual picture of financial performance.

Gross profit doesn’t indicate how efficiently the company is using its resources. It’s simply the amount remaining after deducting COGS from total revenue.

Gross profit varies from industry to industry. Thus, it is difficult to compare companies in all sectors. Companies could not determine which product or service is performing well while considering gross profit.

Last Word

Here we end our story on how to calculate gross profit. Measuring gross profit is crucial for companies as it helps to track whether the product’s price and labor cost are in the appropriate range or not. Moreover, companies can also determine whether the raw material has been used in the right way or not. Firms must consider gross profit for better business running.

Frequently Asked Questions