How to calculate gross profit

Gross profit equals sales for a period minus the cost of goods sold for the same period. In business.gov.au's glossary it is the gap between sales and what it directly cost to make them, and the profit and loss statement is the report it points to for working out gross and net profit.

Both figures must cover exactly the same dates. For a month or a quarter, take each account's movements between that period's first and last days. A year-to-date balance taken partway through the year mixes in earlier months and overstates both sides.

Start with income from selling your goods or services in the period, then adjust it so it reflects what customers actually kept:

• take off refunds and returns given in the period
• take off credits given for faulty goods or work that had to be redone
• take off discounts if your books record them in a separate account rather than in the price.

Leave out income that isn't from trading. Interest received, a grant, money from selling a vehicle and money an owner puts into the business don't belong in sales, so keep them out of the gross profit calculation.

The accounting method matters too. Cash accounting, as business.gov.au describes it, books a sale only once the customer pays; accrual accounting books it when the sale happens. A month with many unpaid invoices shows lower sales on a cash basis, so use one method and keep to it.

business.gov.au's glossary defines cost of goods sold by what is spent directly on producing what was sold, so its contents depend on how you trade:

• Reselling: the cost of the stock that left the shelves in the period, not everything bought; the cost of goods sold guide shows the working.
• Making: materials and production wages for the items sold.
• Services: subcontractors and job materials on client work.

Administrative wages, office rent, marketing and general business insurance commonly sit below gross profit. Costs related to production may be treated differently. Agree with your accountant which costs belong in cost of goods sold and which are operating expenses, then use the same split every period.

The result is positive, so trading covers the costs included above gross profit and leaves an amount towards the other running costs. A negative gross profit means those costs exceeded sales for the period. Check prices, the sales mix, fixed production costs and unusual items before deciding whether more sales would help.

The same subtraction works for each part of the business, as long as sales and direct costs are recorded against separate accounts for each line. Set your chart of accounts up that way and the figures fall out of the profit and loss statement each month.

Installation brings in a fair amount of sales but leaves little once the subcontractors are paid. That is a prompt to look at installation prices or subcontractor costs. business.gov.au's guidance on improving cash flow suggests putting your effort into the customers, products and services that make the most profit.

• Counting every stock purchase as a cost: a large restock in one month makes gross profit look low, then high the month after.
• Using a closing stock figure that was guessed rather than counted. business.gov.au notes that most businesses do a stocktake monthly or quarterly.
• Supplier bills for stock already received but not yet entered, on accrual books.
• A sale or a cost dated in the wrong period, especially around the end of a month.
• Moving a cost such as packaging or delivery wages between direct costs and overheads without restating earlier periods.

Set this period's gross profit beside the same period last year. Where sales have climbed and gross profit hasn't followed, compare each direct cost line with the same period last year to see where the gap opened. business.gov.au's cash flow guidance ties setting prices to knowing both your production costs and the value of what you sell.

Dividing gross profit by sales, when sales are above zero, turns it into a gross margin, which makes periods of different sizes easier to compare. For questions about which costs belong above the line in your business, your accountant can help.