What is Gross Profit?

Gross profit (gross income) is a company’s profit after deducting all the costs associated with production and selling products or rendering services to customers.

The metric is useful in assessing a company’s efficiency in utilizing labor and supplies for producing and delivering goods or services. It only considers variable costs directly related to the company output, such as labor costs, raw materials, shipping and handling costs, etc.

The higher a company’s gross profit, the more efficiently it leverages its resources.

Gross profit appears on a company’s income statement and is determined by deducting the cost of goods sold (COGS) from the company’s total revenue (net sales). Fixed costs like rent, insurance, office supplies, tax payments, etc., do not factor into gross profit. But a portion of these expenses may be assigned to each production unit under absorption costing, which is required for external reporting as per the generally accepted accounting principles (GAAP).

Importance and Interpretation

Gross Profit is important as it provides businesses with a clear way to measure how efficiently they produce products or services.

Suppose a company’s gross profit is high. It makes efficient and profitable decisions regarding allocating production costs or cost of goods sold (COGS). When the value of COGS is less than the net revenue, it means an increase in profit for the company, and the business owner will have more money to spend on the business operations.

If the gross profit is low or negative, the value of COGS is high, and the company will have less money to deal with the operating costs. It may need to rethink its approach toward production, either by increasing its prices or finding ways to reduce costs.

Gross profit can thus help companies to assess areas for price increases or cost cuttings. 

Impact on Financial Statements

Gross profit is generally reported as a separate line item on the income statement or a company’s profit and loss statement. It is calculated by subtracting the COGS from the total sales revenue generated by the sale of goods and services.

The gross profit figure is reported on the income statement before other expenses like depreciation, interest expenses, taxes, etc., are deducted, allowing the investors, analysts, management, and other stakeholders to evaluate the profitability a company retains based on its operations which can be useful for decision-making regarding its growth, resource allocation, and additional investment potentials.

Although gross profit measure is an important financial metric, it does not consider other expenses that can affect a company’s financial health. To get a complete picture of a company’s finances, it is important to look at the net income, which includes all the expenses and taxes as follows;

• Operating Expenses are expenses incurred for normal business operations like rent, utilities, salaries, marketing, etc. They are deducted from the gross profit to calculate operating income and are useful in determining how efficiently the company manages its expenses.
• Depreciation reflects the loss of monetary value of the company’s assets over time and is used to calculate the company’s taxable income. It is added to operating income to calculate Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
• Interest expense represents the cost of borrowing money. It is subtracted from the EBITDA to calculate earnings before taxes (EBT), then subtract the EBT from taxes to arrive at net income. 

Calculation

Gross Profit Formula

The formula for calculating gross profit is; Revenue – Cost of goods sold (COGS)

Components of the Formula:

1. RevenueВ is the total money generated from sales of a company’s products or services during a given period (such as a month or a quarter) before deductions. It can also be called net sales revenue, including discounts and deductions from returned merchandise. Revenue is a top liner that sits on top of the income statement.В Variable costsВ are subtracted from revenue to calculate the bottom line, the cost of goods sold.
2. The cost of goods soldВ includes all the direct costs of producing goods or services. It does not include fixed costs, such as administrative costs, employees’ salaries, or sales and marketing costs. Examples of COGS: are parts or raw materials for machinery needed in manufacturing, direct labor costs, andВ overhead costs, among others.

Steps to Calculate Gross Profit

• Determine the total revenue generated from selling goods or services during a specific period.
• Calculate the cost of goods sold during the same period. It includes all direct costs associated with producing and selling goods or services.
• Subtract the cost of goods sold from the total revenue generated. The resulting figure is the gross profit.

Example

Here is a numeric example of how to calculate gross profit using Company A’s income statement.

Particulars	USD
Revenues
Automotive	1,40,000
Financial services	1,00,000
Other	20,000
Total revenues	2,42,000
Expenses
Automotive cost of goods sold	1,26,000
Selling, administrative, and other expenses	12,000
Financial Services interest, operating, and other expenses	9,000
Total Expenses	1,47,000

Solution: To calculate the gross profit, consider and add up the direct cost of goods sold = 1,26,000

Selling, administrative and other expenses, as well as Financial Services interest, operating, and other expenses, will not be included as these expenses are mostly fixed costs.

Then to obtain gross profit, apply the formula.

Gross profit Formula = Revenue – Cost of goods sold (COGS)

=> 242,000 – 126,000 = $116,000

Gross Profit vs. Net Income

Gross profit (GP) and net income (NI) are two important financial metrics that can be used for evaluating a company’s net profit. GP represents the money left after subtracting cost of goods sold (COGS). NI represents the financial performance of a business entity after deducting operating expenses, taxes, interest, and depreciation. 

Understanding the distinctions between GP and NI can help investors determine the overall production efficiency and areas where the company is earning profits or losing money.

Basis of Comparison	Gross Profit	Net Income
Definition	It is the leftover profit after deducting all direct costs from the production process.	It is an organization’s residual income after paying all its expenses for the period.
Objective	It helps control and minimize costs.	It helps to estimate the proficiency of the company.
Reliability	It helps to ascertain rough profits by only considering the variable costs. So, making financial decisions solely based on the gross profit figure is difficult.	It helps to ascertain actual earnings accrued in a financial period by accounting for taxes, interest, and depreciation.It provides more dependable parameters to formulate business strategies for growth and expansion.
Financial Treatment	It appears on the credit side of the Trading Accounts.	It appears on the credit side of the Profit & Loss Account.
Inclusions	It contains taxes and overhead costs.	It comprises taxes, operating expenses, and interests.
Formula	Revenue – Cost of Goods sold	Gross Profit – Expenses (including taxes and interest)

Is Gross Profit and Gross Profit Margin Same? 

Gross profit and gross profit margin measure a business’s profitability based on revenue and costs of goods sold, but they are not the same. The gross profit figure is an absolute dollar amount that represents a business’s profit from selling its product or services, post-accounting for all the production costs.

Gross profit margin represents the percentage of each dollar of revenue exceeding a business’s cost of goods sold. We can calculate gross profit margin by applying the following formula;

Gross profit margin = Gross profit/revenue x 100.

The higher the gross margin, the more effectively a business generates revenue for each dollar of cost.

Gross profit margin is expressed in percentages, making it a useful tool for business owners to compare their gross profit margin against the competitors. For example, comparing the gross profit of a small business with a large business in the same industry will not give a true picture of their efficiency.

Comparing the gross profit margin of similar entities would give a better understanding of their financials.

So, it is best to compare the gross margin ratios of the business to companies within the same industry and over multiple periods to get a sense of trends and finances. 

Final Thoughts

Gross profit is the sales profit a company retains after subtracting the cost of goods sold from its net revenue. A company can gauge how well it manages its production and delivery costs if the products are being accurately priced, usage of raw materials, and labor costs. The gross profit helps to calculate the gross profit margin, which helps assess a company’s production efficiency over time.

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