Gross profit measures the dollar amount of profit from the sale of a business’s product. It is the dollar amount of sales revenue you have left after paying all the direct costs of producing your product. Gross margin measures by percentage what part of the product’s cost is the sales price. It is the percentage by which sales revenue exceeds the cost of making those sales. Gross profit is an especially important financial metric because it helps a small business owner determine what is affecting the profitability of their business. Find out more about how both statistics are calculated and how a business owner can use each.
What’s the Difference Between Gross Profit and Gross Margin?
Both metrics calculate the amount of sales revenue left after the direct costs of production are subtracted. Those direct costs of production are usually expressed as the cost of goods sold on a business’s income statement.
Calculation of Gross Profit
To calculate gross profit, you need to look at the income statement, also called the profit and loss (P&L) statement, for your business. The first line item on your income statement should be sales revenue. The second line item may represent sales returns, if you sell a returnable product. The next line item will represent the cost of goods sold (COGS). After noting COGS, you have the information you need to calculate gross profit. In equation form, the calculation for gross profit is: Gross Profit ($) = Total Sales Revenue – Sales Returns (if any) – COGS You are comparing profit with sales revenue after subtracting the direct costs of production of the product and taking any sales returns into account to arrive at gross profit in dollars.
Calculation of Gross Margin
You use much of the same information from your income statement to calculate gross margin. In equation form, the calculation for gross margin is: Gross Margin (%) = Gross Profit / Sales x 100 The gross margin calculation allows you to separate COGS from sales to see by how much the cost of making the product reduced the sales revenue you have available to meet other expenses; again, it’s stated as a percentage.
Gross Profit vs. Gross Margin Example
Here’s an example of how a small business might use these calculations. Samantha’s Sewing Shop produces surgical gowns worn by health care workers. During the pandemic, Samantha switched her business model from also making other products to just making surgical gowns, for as long as it was necessary. This is the top portion of Samantha’s income statement: Sales Revenue $20,000 – COGS $15,000 = Gross Profit $5,000 Here is the calculation for Samantha’s gross margin: Gross Margin (%) = $5,000 / $20,000 x 100 = 0.25 x 100 = 25% With sales of $20,000 and COGS of $15,000, Samantha’s gross margin is 25%. This means that 75% of Samantha’s $20,000 in sales revenue went to pay the direct costs of producing the product, as reflected by the COGS. The remaining 25% of her sales revenue is left for paying other expenses, like her fixed costs, taxes, and depreciation. Gross profit and gross margin are two important financial metrics, but neither means much in isolation from other data. Unless you have something against which to benchmark, or compare, all you have are raw numbers. As such, all you know so far in our example is that Samantha covered her product’s cost with 75% of revenue and had 25% left for other expenses. In other words, she earned 25 cents in gross profit for every $1 in sales.
Using Gross Profit and Gross Margin in Your Business
When you look at your gross profit, consider that it is calculated after all direct costs have been subtracted, but indirect costs have not been subtracted. Indirect costs include the office and administrative overhead for your business. It is most informative to look at gross profit as part of trend analysis. Is your gross profit increasing or declining over time? If it is falling, that should be a red flag that your purchasing and sales practices are not as profitable as they once were. Your business is not using raw materials and labor as efficiently as it did in previous years. If this is the case, examine your business policies, as well as how you use your raw materials and labor. There are other issues that gross profit allows you to consider. Has the price of raw materials gone up? What about the wages of your workers? Perhaps even your accounting method has changed, which could affect gross profit. The higher, the better is the rule for gross margin. A high gross margin across several years of data means that your business is generating profitability from the efficient use of raw materials, labor, and manufacturing overhead. If you see a declining gross margin, you want to look at the cost of your raw materials in the production process. You also should see if your labor force has undergone a change or if there is a labor issue raising costs. In addition, you also should look at any changes in the cost of manufacturing overhead. By examining your gross margin, you can determine if your prices are too low or your cost of sales is too high, for example. Analyzing your gross margin allows you to see if you can cut costs over time and increase your gross margin versus previous periods.
The Bottom Line
Gross profit and gross margin both look at the profitability of a business of any size. The difference between them is that gross profit compares profit to sales in terms of a dollar amount, while gross margin, stated as a percentage, compares cost with sales.
