As a finance leader, there is an endless pool of metrics you can choose to track performance.
But there’s one that’s at the top of every CFO’s dashboard: Gross profit.
While net profit represents a company’s earnings for the period, gross profit tells you about the profitability of an organization before looking at indirect expenses like taxes and overheads.
In this guide, we’ll discuss what gross profit is, why it is important to track, how to calculate it, and how it compares to other commonly tracked financial metrics.
What is gross profit?
Definition of gross profit
Gross profit is the revenue a business earns from its sales after accounting for cost of goods sold (COGS).
COGS includes direct costs like materials, labor, and production expenses that go directly into producing the good or service the business sells.
The formula for gross profit is simple:
This metric represents the business’s profits before deducting operating expenses, taxes, and other indirect costs, showing how efficiently the company produces and sells its goods or services.
The importance of gross profit in financial analysis
Gross profit is a key metric in financial analysis. It helps assess a company’s profitability and efficiency in producing goods or services outside of additional real expenses like taxes and overheads.
Gross profit provides insights into:
- Business efficiency: How well a company controls production costs
- Pricing strategy: Whether a company is pricing its products effectively
- Cost management: If costs are too high relative to revenue
- Financial health: Whether a company can cover operating expenses and reinvest in growth
How gross profit impacts business profitability
Gross profit is the foundation of profitability. Net profit is calculated using gross profit as a starting point, then subtracting all remaining expenses.
If gross profit is low, net profit will be low also.
Gross profit impacts business success in several ways. It:
- Determines net profit potential
- Influences pricing decisions
- Affects cash flow and growth
- Signals financial strength to investors
- Helps to identify cost inefficiencies
How to calculate gross profit
Gross profit formula
Calculating gross profit isn’t difficult. You just need two figures:
- Revenue
- COGS (cost of goods sold)
Then, you detract COGS from revenue. Here’s the formula:
Step-by-step guide to calculate gross profit
Let’s walk through how to calculate gross profit with an example.
Step 1: Calculate revenue
First, we’ll determine total revenue. We can pull this number from your income statement (also known as the profit and loss statement).
Or, we can use this formula:
Revenue = Price per unit x number of units sold
In our case, we’ve sold 1,000 units at a per-unit price of $50. Our revenue is calculated as such:
$50 x 1,000 = $50,000
Step 2: Calculate COGS
Then, we’ll calculate your cost of goods sold by adding up all of the direct costs involved in producing our goods, such as raw materials, direct labor, and other manufacturing expenses.
For us, COGS totals $30,000.
Step 3: Calculate gross profit
Next, we apply the gross profit formula, subtracting COGS from total revenue:
$50,000 - $30,000 = $20,000
So, our gross profit for the period was $20,000.
Step 4: Interpretation
Finally, we need to interpret the result.
A positive gross profit means the company is making money on sales before deducting expenses. A negative gross profit means we’re selling products at a loss.
In our case, we made $20,000 in gross profit, which is at least profit.
What we need to know, however, is whether that is high or low compared to previous profits, which highlights the importance of tracking financial metrics like gross profit over time and comparing periods against one another.
Gross profit vs. gross profit margin
Gross profit margin is another financial metric used alongside gross profit.
While gross profit is the absolute dollar amount left after subtracting COGS from revenue, gross profit margin is the percentage of revenue that remains after deducing COGS.
It's another measurement of how efficiently a company produces and sells its products.
The formula for gross profit margin is:
In our previous example, our total revenue was $50,000 and our gross profit was $20,000. So, our gross profit margin would be calculated as such:
($20,000 / $50,000) x 100 = 40%
This means that for every dollar we generate in revenue, $0.40 (40%) is kept as gross profit.
Higher margins mean that the company retains more revenue after covering direct costs, while lower margins may indicate high production costs or pricing inefficiencies.
Gross profit vs. net income
Net income is one of the most commonly tracked financial metrics alongside gross profit. Both speak to a company's profitability but take different kinds of expenses into account.
Here’s the main difference:
- Gross profit: Revenue minus COGS
- Net income: The final profit after deducting operating expenses, taxes, interest, and other costs from gross profit
So, net income uses gross profit as its starting point and then subtracts all remaining expenses from there.
Here’s the formula for net income:
Let’s continue that previous example, where we had a gross profit of $20,000 for the period in question.
The remaining expenses we need to consider are:
- Operating Expenses: $15,000
- Taxes: $5,000
- Interest: $2,000
Applying the formula:
$20,000 - $15,000 - $5,000 - $2,000 = -$2,000
In this case, although we had a positive gross profit of $20,000, our net income was -$2,000, which means we actually lost money for the period.
This highlights the importance of tracking gross profit alongside other metrics like net income.
The importance of both metrics in financial analysis
In financial analysis, we need to take several metrics into account to really understand how a business is performing.
Gross profit is useful for measuring production efficiency and pricing strategy, benchmarking against competitors, and understanding whether COGS is too high relative to revenue.
Net income is useful for reflecting the company’s overall profitability, assessing financial health and sustainability, and accounting for all costs that the company must service with cash inflows.
Revenue vs. gross profit
Revenue represents the total income generated from all sales.
It reflects a company’s overall ability to attract customers and drive sales and is often referred to as the “top line” on an income statement.
Gross profit, on the other hand, is the figure remaining after subtracting the cost of goods sold (COGS) from revenue. This metric provides insight into how efficiently a business is managing its direct production costs.
While revenue gives a broad picture of sales performance, gross profit zooms in on operational efficiency by helping finance leaders understand the profit earned solely from production activities.
While a surge in revenue may seem positive, if rising sales are accompanied by increasing COGS, the gross profit might not see a corresponding boost, which means the company may not actually be increasing its earnings.
Get on top gross profit
Gross profit is an important metric for understanding business performance both from a profitability perspective and from an operational standpoint.
Like most metrics, however, it shouldn’t be viewed in a vacuum.
Instead, gross profit should be used in conjunction with other measurements to get a broader picture of financial health, and compared against the same figure in previous periods to analyze how financial performance is changing over time.
A financial operations platform like BILL can help streamline this reporting and analysis process.
Our powerful reporting suite allows you to:
- Build custom reporting dashboards to stay on top of the metrics that matter
- Create automated notifications to catch abnormalities instantly
- Visualize financial data in a way that helps you communicate better with the wider team
