What is gross profit?

What does gross profit tell you?

It is the first line of profit on the profit and loss account, and the one that says whether the work itself is worth doing. If gross profit is thin, no amount of cutting overheads will save the business, because the problem is in the pricing or the direct costs.

Direct costs, or cost of sales, are the costs that rise and fall with each job or sale: materials, stock bought for resale, subcontractors, and for some businesses the wages of people who do the billable work. Overheads such as rent, insurance, your own phone and the accountant are not direct costs and come off later, to reach net profit.

Gross profit is most useful as a percentage of turnover, the gross margin. A joiner at 55% and a retailer at 30% are both fine for their trade; a joiner at 30% is either underpricing or wasting materials. Watching the margin month by month is how you notice either before the year end does.

A worked example

A joiner's year: turnover £90,000. Materials cost £30,000 and he paid a subcontractor £10,000 to help on two big jobs. Cost of sales is £40,000, gross profit is £50,000, and the gross margin is 55.6%.

Overheads are the van, insurance, phone, tools, accountant and software, £18,000 in all. Net profit is £50,000 less £18,000: £32,000. The gross profit paid for the overheads with £32,000 to spare.

The next year his turnover rises to £110,000 but materials climb to £48,000 and subcontract to £15,000. Gross profit is £47,000 on more turnover, a margin of 42.7%. He is busier and earning less, and the margin line is where he finds out why.

How is gross profit different from net profit?

Gross profit deducts only the direct costs of the sales made. Net profit deducts everything: overheads, depreciation, interest and, for a company, tax. Gross profit tells you about the work; net profit tells you about the business. A business can have an excellent gross margin and lose money because its overheads are too high for its size, and it can have a mediocre gross margin and do well on volume. The two numbers answer different questions and both need looking at.