Every business wants to be profitable. But before your business can earn a profit, it first needs to earn gross profit.
What is gross profit? What’s a good gross profit number? And how do you get from gross profit to regular profit?
Here’s what you need to know.
What is gross profit?
Gross profit is what you get when you subtract all the direct costs of making a product or providing a service from total revenue.
The formula for gross profit is:
gross profit = net sales – cost of goods sold (COGS)
Net sales is what you get by taking your business’ total sales and deducting any returns, discounts, allowances, damaged goods and bad debt.
COGS are any costs that are directly involved in the production of goods and services. Common examples of COGS include:
- Materials costs
- Direct labor costs
- Packaging, freight and shipping costs
- Energy and utility expenses for a production facility
- Machinery and depreciation expenses on production equipment
COGS doesn’t include indirect expenses like:
- Salaries for indirect labour costs—i.e. lawyers, accountants, management, etc.
- Office equipment, utilities, rent, etc.
- Marketing, promotion and advertising costs
- Interest payments
- Licensing and professional fees
Where can I find gross profit?
For example, in Apple Inc.’s most recent set of consolidated financial statements, you can find gross profit (here called “gross margin”) right below COGS (here called “total cost of sales”) on the income statement on page one:
Unlike the two other kinds of profit you’ll find on an income statement—operating profit and net profit—the gross profit margin doesn’t include indirect costs like operating expenses or interest payments. Because of this, gross profit will always be larger than operating and net profit.
What does gross profit tell me?
Because it only takes into account direct costs, your company’s total gross profit margin tells you how efficient your company is at turning raw materials, labour and other resources into sellable goods and services.
The gross profit for a specific service or product line can also help you figure out the profit potential for that service or product.
Being able to sell something at a gross profit doesn’t guarantee that it will eventually turn a net profit, but it’s definitely the first step.
Further reading: Gross Profit vs. Net Profit: Understanding Profitability
Gross profit in action
For simplicity’s sake, let’s imagine a small business—a cafe—that sells one product: individual cups of coffee.
Let’s say the cafe owner calculates that the gross profit margin for each coffee they sell is $1.50.
That means every coffee they sell not only pays for itself, but also contributes an additional $1.50 to the business, which can be used to pay down fixed costs like rent and labor.
Let’s also say that the total fixed costs of running the cafe are $4,000 a month (including rent, utilities, taxes, etc.)
If the cafe owner thinks that the total gross profit generated by the coffees they sell every month can eventually cover all $4,000 of their fixed costs, that the business has the potential to be profitable.
If they don’t think they can sell enough coffees to cover $4,000 in fixed costs, the business does not have the potential to be profitable, and the cafe owner needs to rethink their business model.