What is gross profit?

What is gross profit

What is Gross Profit?

Gross profit (GP) is the difference between a company's total revenue and the cost of goods sold.  In other words, it's the portion of a company's revenue that isn't attributable to the direct costs of producing its products or services.


There are two main ways to calculate gross profit. 


The first is to subtract the cost of goods sold from total revenue. 


Gross Profit = Revenue - Cost of Goods Sold (COGS)


To calculate using this method, you will need three pieces of information:

1) Total revenue for the period 

2) Cost of goods sold for the period

3) Gross profit for the period


The second is to divide total revenue by the gross profit margin.

The gross profit margin is calculated by dividing gross profit by total revenue. 

To calculate gross profit margin, you will need two pieces of information:

1) Total revenue for the period

2) Cost of goods sold for the period

What is Gross Profit and Your Business 

Now that you know what it is and how to calculate it, you may be wondering how it can be used in your business.

 

There are a few key ways that the GP can be used to help your business:


1) To measure profitability

It can be used as a measure of profitability because it tells you how much money a company has left over after paying for the cost of goods sold. This leftover amount can then be used to cover operating expenses and generate a net profit.


2) To compare companies

When trying to compare companies, it's important to use a metric that makes sense for the business being compared. For example, if you're comparing two manufacturing companies, using GP as a measure of profitability would make more sense than using net income because manufacturing companies tend to have high costs associated with their products. Similarly, if you're comparing two service-based companies, using net income as a measure would make more sense than using GP because service companies don't typically have any inventory-related costs.


3) To evaluate pricing strategies

Pricing strategies can have a big impact on gross profit margins.

For example, if a company decides to increase its prices, its gross profit margin will likely increase as well, unless there's a corresponding increase in costs.

Conversely, if a company decides to decrease its prices, its gross margin will likely decrease unless there's a corresponding decrease in costs. Thus, evaluating different pricing strategies can help you make decisions about pricing that will impact both top-line revenue the bottom line profits.


4) To set financial goals

Financial goals should always be realistic and achievable but they should also stretch a company in order to spur growth. As such, when setting financial goals for your business, one metric you may want to consider is GP growth rate. This financial goal tells you by how much you need your gross profits to increase year over year.


5) To Forecast future sales

Forecasting future sales can be difficult because there are so many variables at play (e.g. macroeconomic trends, seasonality, etc.). However, one metric that can help with forecasting future sales is historical gross profit growth rate. If you know how much your gross profits have grown in prior periods (and why they've grown), you'll have a better understanding of how much they might grow in future periods.


As you can see, it is an important metric for businesses because it can be used in a variety of ways to help assess profitability, compare companies, set financial goals, and forecast future sales.

Latest Posts

Profit First Strategies

Profit First Strategies: Mastering Profit First Strategies for Your Small Business

Managing finances effectively is crucial for the success and sustainability of any

Read More
Cash flow managment

Cash Flow Management: 5 Tips for Improving Cash Flow

Cash flow management is the lifeblood of any small business. Without a

Read More

Subscribe to the Friday Financial Freedom Finder Newsletter

Subscribe to our weekly newsletter that delivers the most actionable, tactical, and timely business and financial tips you actually need in 9 minutes or less. Get an edge over the competition and get control of your business finances, for free.

About the Author

Annette Ferguson 

Owner of Annette & Co. - Chartered Accountants & Certified Profit First Professionals. Helping online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.

>