What is Gross Profit and What does it Tell us?

In our last post we discussed what Cost of Sales is and how to calculate it. We talked about how Cost of Sales is used to calculate the gross profit of a company and how gross profit is shown on the Income Statement of a business.

But What is Gross Profit?

Gross profit is the amount of money made from a sale after the costs of the sale are deducted.

If we take a simple example of a business that buys and sells apples:

On day 1, the business purchases one apple for £1. The next day it sells this apple to a customer for £2.

To calculate the gross profit, we simply take the £1 (cost of the apple sold) away from £2 (income generated from selling the apple) which leaves us with £1 gross profit.

In this situation we are able to see that for every apple sold we will make £1 of gross profit. if we sell 1,000 apples a year, in theory this should provide us with £1,000 of gross profit.

Why is Understanding Gross Profit (GP) so Important?

GP is one of the key areas that needs to be understood when analyzing the profitability of a business.

This is because gross profit is used to cover all the other expenses of a business. If a business doesn’t make enough GP to cover it’s operating expenses (rent, electricity etc.) the business could end up in serious financial trouble.

Let’s use the above example to understand this.

Imagine the same apple business pays someone to make posters to advertise the business. The poster-designer gets paid £0.50 a day and this would be classed as an operating expense for the business.

Therefore, out of each day’s gross profit, 50p must be used to pay the poster-designer. As long as the business sells an apple a day it will generate £1 of GP and be able to pay the poster designer’s 50p daily charge with 50p left over as net profit (the profit after ALL expenses are taken into account).

However, if the business doesn’t sell any apples in a day, it suddenly has to find 50p to pay the poster designer. There may be profits from other days that the business can use but then there may not be enough money to buy more apples to sell and suddenly the business is in trouble.

This is why understanding GP is so important. If we don’t know how much profit each item we sell makes, it is very hard to make business decisions.

Where does Gross Profit go in the Financial Statements?

As GP relates to a business’ income/expenses it goes into the income statement.

It can be found in the top section of the income statement right after we deduct Cost of Sales from Revenue.

Here is an example:

Revenue £20,000

Cost of Sales (£10,000)

Gross Profit £10,000

As we can see in the example above, this business has generated £10,000 of GP within the period and from this, we would go on to deduct all the operating expenses of the business to arrive at the total Net Profit.

What Calculations Can We Perform with This Information?

GP is a really useful number and can be used to calculate many financial ratios.

These ratios include:

GP Margin
Mark-up %

Summary

In summary, GP is the amount of profit a business makes looking just at how much each product costs to sell. It provides with an amount that can be used to pay for all the other expenses a business will incur

Understanding GP is crucial to understanding the profitability and performance of a business and it can be used to calculate key financial ratios.

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