Gross profit is the difference between the value of a firm’s revenue and the direct costs of providing its goods or services over a given period. In simple terms, it’s the turnover of the business minus the day-to-day running costs that relate directly to achieving these sales.
The figure provides a handy snapshot of how well a business performs, but it is also the cornerstone that enables us to calculate other essential metrics, such as net profit. This is why it is so vital to get right.
What is the formula for gross profit?
Gross profit = Revenue – Direct costs
This straightforward formula is sometimes described in different terms, which can cause confusion. For instance, revenue might be called turnover or total sales, but this is still merely the full value of whatever the business sold. Direct costs are also commonly called cost of goods sold (COGS) and include variables such as the materials for making the actual goods or the wages of staff who sell them. Rent for a factory-space, or the wages of admin teams are both indirect costs, also known as overheads, and irrelevant to the gross profit.
Let’s look at this example. Avocado Ltd is a fictional firm that makes and sells fruit-shaped furniture in London. Over the past year, it achieved £100k in sales. Fabric and raw material costs are £25k, packaging £10k, and £15k was paid in commissions to the showroom staff.
Gross Profit = Revenue (£100k) – Direct Costs (£25k + £10k+ £15k) = £50k
Want to dig deeper into how this works in practice? Check out this article.
How do you calculate gross profit margin as a percentage?
Gross profit is typically shown as a currency value for a specific period and indicates how profitable a business is before taking overheads into account. That said, a far more useful number is the gross profit margin as this reveals how much profit the firm makes for every pound it generates in sales before indirect costs are accounted for. The method is below, and the answer is either given as a simple ratio or a percentage, as we have done here:
Gross Profit Margin (%)= (Gross Profit / Revenue) / 100
Taking our earlier example, the gross profit margin for Avocado Ltd is as follows:
Gross Profit Margin (%) = (£50k / £100k) 100 = 50%
It’s tricky to say what constitutes a ‘good’ level of gross profit margin as this varies so widely between industries or sectors. For instance, food retailers operate on tighter margins than luxury goods and rely on high volumes to make up for it.
What is the difference between gross and net profit?
Net profit = Gross Profit – Indirect Costs
Net profit, sometimes also called the bottom-line profit, is the gross profit minus the firm’s indirect costs. These are the costs which do not contribute directly to sales output, such as buying plant machinery or paying accountancy fees. We cover net profit in more detail here and explain what insights each of these two different types of profit reveal about the way that a business performs in our article Gross profit vs Net profit.Sign up in minutes
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