The gross profit of a company is the total sales of the firm minus the total cost of the goods sold. The total sales are all the goods sold by the company. The total cost of the goods sold is the sum of all the variable costs involved in sales.
When calculating the total sales figure the business must total all goods sold over the chosen financial time period. This total cannot include the sale of fixed assets such as a building or equipment. A clothing store, for example, will give the total amount of money generated from the sale of its stock of clothes as the total sales figure.
To calculate the costs of goods sold figure, the store must total all costs involved in selling the clothes to customers. These are variable costs only and are ones that may fluctuate with the level of sales. This will include such costs as:
Fixed costs such as rent, office equipment, wages of non-sales staff, insurance, bank costs and advertising are not included in calculating the cost of goods sold figure.
For a store to compare only the gross profit figure from one period to another is a dangerous method of judging how the store is performing. The gross profit figure may stay the same or even increase while the gross profit margin may be on the decrease and point to trouble ahead for the store. The store will use the gross profit figure to generate the gross profit margin, which is a better indicator of the efficiency of the store over any time period chosen. When writing a gross profit figure the store does so in terms of a currency value.
Gross Profit = (Total Sales – Total Costs of Goods Sold)
The gross profit margin however is a percentage figure and the store calculates this using the formula:
Gross Profit Margin = (Gross Profit / Total Revenues) x 100
The store may use the gross profit margin to compare with the industry average to see if it is performing well in the market. If the gross profit margin is below expectations or on the decrease, the store should examine the gross profit figure and see what costs need addressing or any ones that may need cutting.