Gross Profit

Gross profit is an essential profitability metric for business owners. Learn how to calculate gross profit, use the gross profit formula, and see examples.

What is Gross Profit?

Gross Profit is the profit that a company makes after removing the direct costs associated with generating sales. Gross Profit is listed on the income statement and the formula is Net Sales minus Cost of Goods Sold (COGS).

The income statement is one of three primary financial statements, along with the balance sheet and cash flow statement. Listed on the income statement are all revenues, expenses, and any profit or loss for a company in a given period.

At the top, you have three important items:

  • Net Sales: Your total sales less your discounts, refunds, returns, and allowances.
  • Cost of Goods Sold: All direct labor and direct materials associated with generating sales.
  • Gross Profit: Your net sales less cost of goods sold.

The relationship between revenue, COGS, and gross profit is a vital one to understand. In this post, we are going to walk through the gross profit formula, several examples of the gross profit calculation, the definition of gross margin, and more.

Gross Profit Formula

The Gross Profit formula is Total Revenue less Cost of Goods Sold.

Total Revenue is also called Total Income, Gross Income, or Net Sales and refers to the income that a business generated in a period by selling products and services. When looking at income, you must add up all the different income streams and subtract out any discounts, refunds, returns, or other allowances.

Cost of Goods Sold measures the direct costs involved with selling products or providing services to customers. If you are a shoe store, this line item would be all costs involved in selling shoes. These are variable expenses and will change as you sell more units.

For a clothing company, the COGS line item would includes:

  • Wages of your sales and fulfillment staff
  • Purchasing your merchandise from a supplier, if you buy inventory
  • Raw materials and direct labor costs, if you produce inventory
  • Portion of rent and utilities, if you have warehousing or manufacturing areas in your office
  • Shipping product to and from your facility
  • Credit card and other payment processing fees
Gross profit is revenue minus cost of goods sold, the direct costs associated with making sales.

Fixed costs are not included in the cost of goods sold calculation. Expenses like rent, office supplies, insurance, legal fees, marketing, amortization, and depreciation are considered operating expenses and captured lower down on the income statement.

Gross Profit Examples

Here are three examples of how to calculate gross profit…

Company A

  • Total Income: $550,000
  • COGS: $367,000

Gross profit is simply total income minus COGS. In this case, $550,000 minus $367,000, so gross profit is $183,000.

Company B

  • Total Income: $1,000,000
  • COGS: $825,000
  • Operating Expenses: $250,000

As with above, we want to subtract COGS ($825,000) from revenue ($1,000,000) to get our gross profit of $175,000.

Operating expenses are below gross profit so we do not need to factor them in. This is simply extra information that is not needed for this calculation.

Company C

  • Services Sales: $1,000,000
  • Subscription Sales: $1,200,000
  • Sales Discounts & Allowances: $85,000
  • COGS: $1,400,000
  • Operating Expenses: $950,000

For Company C, we need to first find net sales before we can subtract the cost of goods sold. We want to add services sales ($1,000,000) to subscription sales ($1,200,000) to get $2,200,000 for gross sales. Then we back out $85,000 of our sales discounts and allowances, to get a net sales figure of $2,115,000.

Now we simply take $2,115,000 and subtract $1,400,000 for a gross profit of $715,000.

Remember that gross profit appears directly after cost of goods sold on the income statement and before items like general and administrative, non-operating revenue, and non-operating expenses. Company B and Company C provided us with operating expenses, but we do not need them to calculate gross profit.

Gross Profit vs. Operating Profit vs. Net Profit

In business, there are different types of profit. It’s important to understand the difference between these definitions and to track each type of profit carefully. Let’s dig into the differences.

Gross Profit: Income – COGS. It’s the profit left after accounting for direct costs that go into selling your product or service. For a clothing company, gross profit would be net sales less the cost of your inventory.
Operating Profit: Gross Profit – Operating Expenses. It’s the profit left after accounting for your ordinary business expenses, depreciation, and amortization. It is also called Earnings Before Interest and Taxes (EBIT).
Net Profit: Operating Profit – Interest – Taxes. It’s the profit left at the end of the day, including all expenses. This is the most strict profit definition and will be the lowest value of the three.

Now we simply take $2,115,000 and subtract $1,400,000 for a gross profit of $715,000.

As you can see, these profit definitions build on one another. Gross profit is at the top of the income statement and you need to know your gross profit before you can calculate operating profit (also called EBIT). Once you have operating profit, you can remove interest expense and taxes to get to net profit.

Gross Margin

Gross margin, also called gross profit margin, is the ratio of gross profit to total revenue. While gross profit is expressed as a dollar value, gross margin is a percent.

In simple terms, gross margin shows you what percent of your sales is left after you pay for direct costs. Companies will want a higher gross margin as this will allow them to have more money left to cover fixed overhead and generate profit.

The gross margin formula is: (Gross Profit / Total Revenue) x 100

You can improve your gross margin by increasing the selling price for products and services, reducing direct material costs, and reducing direct labor costs. Changing items below the line (like sales expenses, marketing expenses, legal fees, or taxes) will not change gross margin.

Profitability Ratios

As discussed above, gross margin is a common profitability ratio. We have included a few more examples that describe other parts of the business. The first three are different ways of looking at how much profit you have compared to overall sales.

Operating Margin: Operating Profit divided by Total Revenue; also called Operating Profit Margin
Net Margin: Net Profit divided by Total Revenue; also called Net Profit Margin
EBIT Margin: EBIT divided by Total Revenue; also called Operating Margin
EBITDA Margin: EBITDA divided by Total Revenue
Return on Assets (ROA): Net Income / Total Assets; a measure of how much profit a business can generate from their assets
Return on Equity (ROE): Net Income / Total Equity; a measure of how much profit a business can generate with the equity invested
Profitability ratios are a group of financial metrics that track a company's ability to earn a profit. Examples include operating margin, net margin, EBIT margin, EBITDA margin, return on assets, and return on equity.

The last two metrics look at your profitability and efficient utilization of capital. All things equal, a company will want a higher ROA and ROE because this lets them generate more profit for each unit of input. For example, a company with 2x the ROA of their direct competitor would be able to generate the same profit with half of the investment in short-term and long-term assets.

Final Thoughts

Small business owners, managers, investors, and analysts all look to gross profit and gross margin as an indication of how much pricing power a business has. Companies that can demand a higher markup, and thus have a higher gross profit, are in a stronger financial position. This is because gross profit can be used to cover overhead costs and, once all overhead is paid for, the rest falls to the bottom line as net profit.

Gross profit is a powerful financial metric that can be used to quickly identify problems for a company. For example, if gross profit has been declining over several periods then it may be time to implement stricter controls to manage your variable costs.

Here are some key takeaways:

  • Gross profit equals net sales minus cost of goods sold (COGS)
  • Gross margin is gross profit divided by net sales
  • All things equal, companies want higher gross profit and gross margin as it leaves more resources to cover their overhead and fixed expenses
  • Investors, analysts, and lenders will look at gross profit (as well as net profit) as a sign of the health of the business
  • Optimizing things like rent, salaries, insurance costs, legal fees, and taxes will improve your net profit (bottom line) but not gross profit

Whether you’re a manufacturer, a wholesaler, or a retailer, you should consider how to improve your business operations to have steady and predictable gross margins. Healthy businesses will have a high gross profit to cover indirect costs including payroll, employee benefits, rent, utilities, insurance, interest expense, taxes, and more.

Start for free today.

Track metrics like the top performing ecommerce stores.