June 16, 2022
If you’re trying to calculate how much money your business is making you might be wondering what Gross Profit is, how it differs from net profit, and how to calculate Gross Profit.
The good news is that while many accounting terms can be confusing, this one is fairly simple to understand. So let’s take a closer look at Gross Profit meaning, and how you can work out what yours is.
The first thing you need to know when you’re calculating Gross Profit is what it is.
Gross profit is the amount of money you have left from the sale of goods and services after you have deducted the direct cost of the goods sold (materials and direct labour.)
This differs from net profit in that net profit also has other things like business overheads and other costs that are not directly linked to any one sale deducted. So Gross Profit is less accurate than net profit, but it’s a good way to get a quick snapshot of how profitable your sales are.
So while Gross Profit won’t tell you exactly how much money you’re making across the board, but it will tell you what kind of profit you’re making on each sale.
When you are in business, very often, your pricing is based on various assumptions and estimates. If you have a service business, you might estimate the amount of time a job will take. If you manufacture products, there might also be assumptions and estimates built into the pricing for those products.
Tracking the Gross Profit on each sale helps you to measure whether your assumptions were correct. If you expected to make a particular margin on the sale, calculating Gross Profit will tell you if you met that goal, or whether you made more or less. This can help you to price future sales more accurately.
When you are calculating Gross Profit, you only deduct the direct cost to produce or sell a product or service. You do not include any general office costs, administration costs, overheads for your head office or marketing or advertising, for example.
These costs will be calculated separately of course, and they will be deducted from your overall revenue to give you a more accurate profit figure, but they are not part of the Gross Profit calculation.
Gross Profit=Revenue−Cost of Goods Sold
Let’s imagine that you start a business selling dog leashes and harnesses. In order to manufacture the leashes and harnesses, you need to purchase webbing, various hardware and clips and thread. You also need to hire a sewing machinist to make the product.
When you sell the product, it will be packaged with labels, and you will need some storage space to keep orders until they ship. All of those costs, as well as any other materials, direct labor and costs that are specific to the manufacturing of your product are COGS, or cost of goods sold.
So, if your total sales revenue for the year is $100,000 but it costs you $55,000 to manufacture the leashes and harnesses, your gross profit would be $45,000.
When you do calculate net profit, the difference between that figure and your Gross Profit can also tell you important information about your business and your pricing. If you are making a good Gross Profit but much less net profit, then you might need to adjust your pricing to include more overhead costs.
The amount of Gross Profit you need to make on every sale differs by industry and product or service type, but usually, you want to make about 50% Gross Profit on every sale. Of course, you need to ensure that this falls within what the market will bear, or you might not make enough sales.