What is Gross Profit?

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Gross profit is the difference between what a company makes by selling goods and services and what it costs to produce those goods and services. Gross profit does not take account of fixed costs, which are largely the same regardless of the quantity the company produces and sells. Gross profit shows how lucrative an increase in sales will be and how well a company can withstand a drop in sales.

Calculation

  • Gross profit is calculated by taking a company's net sales and then deducting the cost of goods sold during the accounting period. The figure therefore only takes account of the money that a company can specifically assign to the production of the goods that it sold. For a retailer, this can be the cost of buying the goods in the first place. For a manufacturer, this can be the cost of raw materials, packaging, and the appropriate share of labor and transport costs. To calculate this precisely, an accountant must only include the money paid to staff while they were specifically working on the goods or supervising production.

Exclusions

  • Gross profit does not take account of overheads, which are costs not specifically related to specific goods. This can include labor costs for staff in roles other than production, legal costs, marketing costs and rent. Gross profit also does not account for financial costs such as taxation or interest payments on debts. The measure of revenue minus all costs is known as net income.

Classification

  • It can be difficult to decide exactly which costs count when calculating gross profit and which do not. As a general principle, costs that vary depending on the quantity of goods produced should be included in the calculation, while those that remain fixed should not be included.

Significance

  • The gross profit can be divided by the total sales revenue to give a percentage figure, or the gross profit margin. This may show how well a company is doing at making individual sales profitable. It can also show vulnerability: a company with a low gross profit margin is more likely to experience financial problems if sales drop. This is because there is less room to save costs by cutting production; put another way, fixed costs make up a higher proportion of total expenditure.

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