What is gross profit?
Gross profit is the amount of money generated from selling a product or service after any direct costs. It’s what’s left after you subtract all the production costs of a product or service from total revenue generated.
Because of this, gross profit is the first step in establishing a positive cash flow. If you don’t turn a gross profit, you won’t generate a positive cash flow because your sales are actually costing you money.
The gross profit formula is:
gross profit = net sales revenue – cost of goods sold (COGS)
Net sales revenue 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. They are a variable cost meaning that they change month to month based on the scale of production. 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 or administrative expenses from business operations 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
- Credit card processing fees
Where can I find gross profit?
For example, in Apple Inc.’s 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 or net profit—the gross profit margin doesn’t include every business expense. Indirect costs like operating expenses or interest payments aren’t included in the calculation. Because of this, gross profit will always be larger than operating or net profit (also called net income or “the bottom line”).
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What does gross profit tell me?
Calculating gross profit or 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. It’s a key metric for early stage business owners to identify the amount of product or services they’ll need to sell to cover their overhead costs and turn a net profit.
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
An example of gross profit
For simplicity’s sake, let’s imagine a small business—a cafe—that sells one product: individual cups of coffee.
The cafe owner does a gross profit calculation to see how much they’re making on each cup of coffee. After running the numbers, they find 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 their day to day business operations are $4,000 a month (including rent, utilities, taxes, etc.)
The cafe owner knows they need to sell enough coffee to cover their $4,000 of fixed costs to have a positive net income and turn a profit. Or, to put it in other terms: the total gross profit needs to cover all $4,000 of their fixed costs to potentially be a profitable business.
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.