Every business wants to make a profit. While you may be tempted to only look at net profits (the money you have left after deducting all your expenses), and ignore the gross profits, gross profits are equally important. Learning how to calculate your gross profits can give you valuable insight into your company’s financial performance.
This guide will cover:
- Gross profits versus net profit in business
- Difference between gross profits and net income
- How to calculate gross profits
- Gross profit margin
- How to calculate gross profit margin
Gross profit versus net profit in business
What is the difference between net and gross profit? It’s actually quite simple.
Gross profits are the money you make after deducting the costs that come from making and selling your products or providing your services – your Cost of Sales.
Your gross profits should show up on your business’ income statement and may also be referred to as sales profit or gross income. You calculate your gross profit by subtracting your Cost of Sales amount from your revenue. We’ll explain these terms in more detail and show you how to calculate gross profit later in this article.
Net profit, on the other hand, is the money you make after subtracting all your operating, interest and tax expenses as well as your Cost of Sales. So knowing your gross profit can help you calculate your net profit. If the number for your net profit is negative (below zero), it’s called a net loss.
Net profit is also referred to as net income or “the bottom line”. Read this guide to find out more about the difference between gross and net profit.
How to calculate gross profit
Calculating your company’s gross profit is relatively simple. The gross profit formula is as follows:
Gross Profit = Revenue – Cost of Sales
Simple, right? Let’s take a closer look at the different parts that make up this formula:
Revenue refers to the amount of money you make from selling your products or services during a specific time period (usually a month, quarter or year) before making any deductions.
Cost of Sales
Cost of Sales refers to the direct costs associated with producing a product. They include:
- Depreciation: this refers to how items lose value over time.
- Facility overheads: costs from running the facility where you make your products, such as bills and rent.
- Labour: if you have employees or outsource manufacturing to someone else.
- Materials: raw materials you need to make your products.
- Storage: costs from storing your products to keep them fresh, such as a fridge or storage facility.
It’s important to note that Cost of Sales does not include administrative or marketing charges since they’re not directly linked to making your products.
To fully grasp how gross profits work, you have to understand the difference between variable and fixed expenses.
These costs are consistent and don’t change based on production. Examples of fixed expenses include:
- Property taxes
On the flip side, variable expenses can change based on how much you produce. These variable costs could be:
- Materials used
- Shipping costs
- Labour costs
Both fixed and variable expenses play a huge role in your company’s gross profit. The more you can keep your fixed costs down and lower your variable costs, the more gross profit you can expect.
You can also claim some of these costs as business expenses, which we explain more about in this downloadable guide.
How this formula works in practice
Let’s say you own a small business that sells organic soaps. If you sell each soap at £10 and sell 50 in one month, you’ll have made £500.
£10 per organic soap x 50 soaps sold = £500 in sales
However, you also need to pay for supplies and other things you need to make the soaps. In this case, costs directly linked to making a sale would be the raw materials you need to make the soaps, plus packaging to put them in.
Let’s say you spend an average of £5 to make each soap. In that case, the total Cost of Sales for the 50 soaps would be £250.
£5 cost per soap x 50 organic soaps to sell = £250 in Cost of Sales
Now take your total revenue and subtract your Cost of Sales, as shown below:
£500 in organic soap sales – £250 paid to make the soaps = £250 gross profit
As we’ve explained, gross profit is the money you have available after paying for the goods or services that allow you to make the sales in the first place. You’ll most likely use this amount to buy more supplies to make more organic products, advertise your business and maybe pay yourself some of it as dividends.
Gross profit margin
You might think that gross profits and gross profit margins are the same, but these metrics measure different things. While gross profits show you the amount of money you have after deducting your Cost of Sales, your gross profit margin shows how much your revenue exceeds your Cost of Sales in percentage terms.
Gross profit margin demonstrates how well your company generates revenue from the costs involved in producing the goods and services. The higher the margin, the more money your business makes for each £1 it receives.
How to calculate gross profit margin
Below is how you calculate your gross profit margin:
Gross profit margin = Gross profit (Revenue – Cost of Sales) ÷ Revenue
It’s important to keep track of both gross profits and gross profit margin. Since your profit can rise while your margins fall, it can be misleading to only focus on one and leave out the other.
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