Gross profit and margin: how to use the formula.

What gross profit means

Gross profit is what is left from your sales once you take off the costs that go up and down with those sales. It comes before rent, wages for office staff, insurance, software and the other running costs of the business. Those come off afterwards to give net profit.

It answers a simple question. Is the core thing you sell making money before overheads? If gross profit is thin, no amount of saving on overheads will fix the business. If it is healthy, the question becomes whether you sell enough to cover the overheads.

The gross profit formula

Sales means your income from selling goods or services in the period. Cost of sales, sometimes called cost of goods sold, means the direct costs of producing what you sold in that same period.

The margin turns the pound figure into a percentage, which lets you compare one month with another even when sales change. A gross margin of 60% means that for every £1 of sales, 60p is left to pay overheads and leave a profit.

What goes into cost of sales

Cost of sales should only hold costs that rise and fall with what you sell. The detail depends on the business, but it usually includes:

• Stock and materials. Goods bought to sell on, ingredients, and raw materials used to make products.
• Direct labour. Subcontractors or staff whose time goes straight into the job or product, such as site labour on a building job.
• Delivery and packaging. Postage, couriers and packaging for goods sent to customers.
• Sales commission. Fees charged per order, such as marketplace or delivery platform commission. Some businesses put these in overheads instead. Either can work if you choose one place and keep to it.

It should not include rent, office wages, accountancy fees, insurance, software subscriptions, loan interest or the cost of equipment. Those are overheads or capital items, and they belong lower down the profit and loss report.

For tax, HMRC lists "things you buy to sell on, for example stock or raw materials" as an allowable expense for the self-employed. How you group costs in your own reports does not change what you can claim, but tidy groups make the return easier to prepare.

Why stock matters

If you hold stock, purchases in a month are not the same as cost of sales. You may buy a large order in March that you sell through April and May. Counting it all in March makes March look poor and the next two months look too good. Salons selling retail products meet the same issue; see bookkeeping for hair and beauty salons.

The fix is a stock adjustment:

Opening stock is the value at the start of the period. Closing stock is the value counted at the end, usually at cost. The difference between the two is taken into cost of sales, so only the stock you actually used or sold is counted.

Without a stock count, gross margin drifts from month to month for reasons that have nothing to do with trading. Many businesses count stock at each month end, or at least each quarter end and the year end.

A worked example

Now suppose the café's supplier prices rise by 10% and its own prices stay the same. Cost of sales goes from £7,000 to £7,700. Gross profit falls to £12,300 and the margin drops from 65% to 61.5%. Sales did not change, but £700 of profit went in one month. Spotting that early is the main reason to watch the margin.

Margin and markup are not the same

Margin and markup use the same two numbers but divide by different things. Mixing them up is one of the most common pricing mistakes.

• Margin is gross profit as a share of the selling price.
• Markup is gross profit as a share of the cost.

Take a product that costs £6 and sells for £10, both excluding VAT. Gross profit is £4. The margin is £4 ÷ £10 = 40%. The markup is £4 ÷ £6 = 66.7%.

So if you want a 40% margin, adding 40% to cost is not enough. £6 plus 40% is £8.40, which gives a margin of only 28.6%. To price for a target margin, divide the cost by one minus the margin. For a 40% margin on a £6 cost, that is £6 ÷ 0.6 = £10.

How VAT affects the calculation

If you are VAT registered, work out gross profit on figures excluding VAT. The VAT you charge on sales belongs to HMRC, and the VAT you pay on purchases is usually reclaimed. Neither is your income or your cost.

A common slip is to take sales from the till or bank, which include VAT, and costs from supplier bills excluding VAT. That overstates the margin. If a £12 sale includes VAT at 20%, the sale for margin purposes is £12 ÷ 1.2 = £10.

If you are not VAT registered, use the full amounts you pay, as you cannot reclaim the VAT. Watch your sales total as it grows. You must register for VAT if your taxable turnover for the last 12 months goes over £90,000, or if you expect it to go over £90,000 in the next 30 days alone. Prices that worked before registration may need another look once VAT applies.

Two VAT terms that sound similar

• VAT margin schemes. These are for second-hand goods, works of art, antiques and collectors' items. You pay VAT at 16.67% (one-sixth) on the difference between what you paid and what you sold for. That is a VAT rule, not a way of measuring gross margin, but it does mean the margin on each item drives your VAT bill.
• Flat Rate Scheme, limited cost business. If you use the VAT Flat Rate Scheme and your spending on goods is less than 2% of your turnover, or more than 2% but less than £1,000 a year, you are a limited cost business and pay a flat rate of 16.5%. What counts as goods follows HMRC's own rules, so it will not always match your cost of sales.

Why your gross margin moves

When the margin changes, the cause is usually one of these:

• Supplier prices. Costs went up and your prices did not.
• Sales mix. You sold more of a low-margin line and less of a high-margin one.
• Discounts and offers. Promotions, vouchers or platform offers cut the price received.
• Waste and theft. Spoiled food, damaged goods or missing stock show up as higher cost of sales.
• No stock count. Purchases were not adjusted for stock still on the shelf.
• Coding errors. An overhead was coded to cost of sales, or a supplier bill was entered twice.
• Timing. Sales were recorded in one month and the related costs in another.

The last three are bookkeeping problems, not trading problems. Checking them first saves you from changing prices because of a coding mistake.

Finding the figure in your software

Most accounting software, including Xero, QuickBooks, Sage and FreeAgent, shows gross profit on the profit and loss report. It does this by adding up the accounts set as cost of sales or direct costs and taking them from sales.

That means the figure is only as good as the coding. Check that:

• Stock, materials and direct labour accounts are set as cost of sales in your chart of accounts
• Overheads such as rent, utilities and software are not in that group
• Supplier bills are posted in the month they relate to
• A stock adjustment is posted at each period end if you hold stock
• Sales from platforms are recorded at the full sale value, with their fees shown as a cost, rather than only the net payout

The last point matters for anyone selling through delivery apps or marketplaces. If you only record the amount that reaches your bank, sales and costs are both understated, and the margin you see is not the margin you earn. Our guide to cash flow explains why profit and cash can tell different stories.

Using gross profit to make decisions

Once the figure is reliable, it becomes a practical tool:

• Pricing. Set prices from a target margin, not a markup guess.
• Break-even. Divide monthly overheads by your gross margin to see the sales you need.
• Product lines. Compare margins by product or service to see which ones carry the business.
• Supplier talks. Show the effect of a price rise in pounds before you agree to it.
• Early warning. A falling margin over two or three months is a signal to act, before it shows up as a cash problem.

All of this depends on books that are up to date. A margin worked out from records that are two months behind tells you about the past, not about this week. Our guide to daily vs monthly bookkeeping covers that trade-off, and how to read a balance sheet explains where closing stock appears.