What is Gross Profit?

When a business buys products for resale or buys raw materials to transform into products, gross profit is an important number to know.

What is Gross Profit?

Gross Profit is the difference between what a product or service sells for and what it costs a business to deliver the service or buy the product for resale or manufacture the product by buying materials and transforming the materials into a saleable product. Gross Profit is calculated by taking the Sales Price minus Product or Service Costs.

How to Calculate Gross Profit for a Service Business

For a business offering services, such as housecleaning, pet sitting, or a beauty salon, Gross Profit is calculated by determining the costs of delivering the service and then subtracting those costs from the revenue received for those services. For a housecleaning service those costs include labor and supplies. The costs of running the business–insurance, rent, and office supplies–are not included for the purposes of determining Gross Profit.

For example, Betty’s Maids has $10,000 in revenue for the month of May. The company paid $6,000 in wages, and had $1,000 of cleaning supplies expense. Gross Profit for the month of May is:

$10,000 Revenue – $6,000 Wages Expense – $1,000 Cleaning Supplies Expense = $4,000 Gross Profit

From the Gross Profit amount, the general expenses of the business (Rent, Insurance, Office Supplies) are subtracted to reach Net Profit or Net Income for the month.

How to Calculate Gross Profit for a Merchandising or Retail Business

For a business selling merchandise, such as a grocery store or an online store, Gross Profit is calculated by determining the costs of purchasing the goods for resale and then subtracting those costs from the revenue received for those products. For a retail business those costs include the cost of the merchandise, freight costs for the merchandise, labor to sell the merchandise. The costs of running the business–insurance, rent, and office supplies–are not included for the purposes of determining Gross Profit.

For example, Joe’s Groceries has $10,000 in revenue for the month of May. The company paid $5,000 in merchandise and freight costs, and had $3,000 of wages expense. Gross Profit for the month of May is:

$10,000 Revenue – $5,000 Cost of Goods Sold (or Cost of Merchandise Sold) – $3,000 Wages Expense = $2,000 Gross Profit

From the Gross Profit amount, the general expenses of the business (Rent, Insurance, Office Supplies) are subtracted to reach Net Profit or Net Income for the month.

How to Calculate Gross Profit for a Manufacturing Business

For a business manufacturing a product, such as a food manufacturer or a toy manufacturer, Gross Profit is calculated by determining the costs of manufacturing the products and then subtracting those costs from the revenue received for those products. For a manufacturing business those costs include the cost of purchasing raw materials, the cost of labor to turn the raw materials into a product, and machinery costs. The costs of running the business–insurance, rent, and office supplies–are not included for the purposes of determining Gross Profit.

For example, Amanda’s Birdhouses has $10,000 in revenue for the month of May. The company paid $4,000 in raw materials costs, and had $3,000 of wages expense. Gross Profit for the month of May is:

$10,000 Revenue – $4,000 Cost of Goods Sold (Materials) – $3,000 Wages Expense = $3,000 Gross Profit

From the Gross Profit amount, the general expenses of the business (Rent, Insurance, Office Supplies) are subtracted to reach Net Profit or Net Income for the month.

Why is Gross Profit Important?

Gross Profit is an important Profitability measurement. The costs of delivering a service, purchasing merchandise, or transforming raw materials to products have a direct relationship to a company’s profitability.

Gross Profit is a quick measure of the relationship between selling price and costs. It serves as a benchmark number that can be compared from month to month, quarter to quarter, and year to year.

An increase in the costs decreases Gross Profit making the company less able to pay its bills, fund growth, and purchase new materials or merchandise. An increase in labor costs or materials costs, or both, impacts the profitability of the company.

As an example, let’s look at what happens to Gross Profit under two different scenarios for Amanda’s Birdhouses, increasing costs and decreasing costs.

	Current Month	Costs increase 2%	Costs decrease 2%
Revenue	10,000	10,000	10,000
Cost of Goods Sold	7,000	7,140	6,860
Gross Profit	3,000	2,860	3,140

Because the Gross Profit number shows the relationship between Selling Price and Costs, it is a bellwether measurement of the health of a business. It signals when profitability is dropping and indicates that selling prices may need to be increased to offset costs.