Gross Profit
A firm's profit after deducting the costs of producing and selling its products or delivering its services
What Is Gross Profit?
A firm's profit after deducting the costs of producing and selling its products or delivering its services is called gross profit. It is calculated by subtracting the cost of goods sold (COGS) from a company's revenue, as stated on the income statement.
It represents a company's earnings from its primary business activity, i.e., the profit obtained after deducting all direct expenses such as raw material costs, labor costs, and other expenses from a company's immediate income.
A company achieves profit after deducting all costs associated with producing and distributing its goods or services. The total sales comprise all sold goods but not assets. A firm's gross profit measures how efficiently it uses its resources to produce goods or deliver client services.
Profitability and financial performance are strongly reliant on this figure, and a decrease in gross profit may indicate a decrease in the efficiency of using resources but does not necessarily mean a company is incurring a net loss.
Key Takeaways
- Gross profit is the profit a company earns after subtracting the cost of goods sold (COGS) from its revenue. It represents earnings from the primary business activity, excluding indirect expenses.
- Gross profit is obtained by deducting direct expenses like raw material and labor costs from immediate income. It reflects how efficiently a company utilizes resources in producing goods or delivering services.
- While gross profit measures operational efficiency by focusing on production costs, it does not determine overall profitability. Net profit considers additional factors like fixed costs and is distinct from gross profit.
- Investors should be cautious, as gross profit overlooks indirect expenditures and may not provide a complete picture of financial performance.
Understanding Gross Profit
Gross profit measures the efficiency of a company's labor and supplies in creating goods or services in terms of variable costs.
The statistic focuses on variable costs, which are costs that change in response to the level of output, such as
-
Materials
-
Direct labor (Hourly or otherwise output-dependent)
-
Salespeople's commissions
-
Customer purchase fees charged via credit cards
-
Equipment (including depreciation based on usage)
-
Production site utilities
-
Shipping
When a firm evaluates its operations and sales, gross profit is critical as it indicates the efficiency of the company in creating goods or services, but it does not determine if the company made or lost money on its sales.
In the broadest sense, a business that does not make a profit is failing. This is because it contributes to assessing a company's efficiency by comparing its gross profit to that of other companies.
A company is more efficient and has more money to reinvest in itself if it produces more gross profit by cutting expenses or increasing sales compared to competitors. Fixed costs are not included in it, as commonly characterized.
However, under absorption costing, which is needed for external reporting under generally accepted accounting principles (GAAP), a portion of the fixed cost is assigned to each production unit.
For example, if a manufacturer produces 10,000 widgets in a particular period and pays $30,000 in rent for the facility, absorption costing would assign a $3 cost to each device.
Operating profit should be distinct from gross profit. These terms have different meanings from each other. Operating profit is derived by reducing operational expenses from gross profit.
Gross Profit Margin
Another statistic can be calculated: the gross profit margin. This statistic is important for measuring the efficiency of a company's production over time.
Comparing gross profit from year to year or quarter to quarter can be deceiving because this profit may climb while gross margins shrink, which is a concerning pattern that could find a company in hot water.
Although the terms are similar (sometimes used interchangeably), gross profit and Gross Profit Margin represent different aspects.
Based on net revenue, gross profit, and Gross Profit Margin are good indicators of a company's profitability.
However, because operating expenses, interest, and taxes are not included in the ratios, they indicate operational efficiency but are not an absolute indication of net profitability.
Analysts and investors commonly use multiple financial ratios to assess a company's performance. To get a sense of any patterns, analysts and investors compare the ratios of the organization to other companies in the same industry and throughout multiple periods.
Gross profit is the difference between a company's revenues and its cost of sales, or the cost of goods sold. The items offered here represent the costs involved in the manufacturing process, including labor, raw materials, and manufacturing overhead.
Note
It is important to note that the cost of goods sold is removed from the company's net sales/revenue, resulting in gross profit.
Gross Profit Margin is a ratio that depicts the connection between a company's gross profit and net revenue. It's used to see how effectively a corporation uses
- Raw materials
- Labor
- Manufacturing-related fixed assets to make money
A larger Gross Profit Margin% shows that the company's profits are positive. Increased or decreased raw material costs have a significant impact on this ratio.
Retailers and service businesses without a traditional manufacturing process may not have a cost of goods sold, but they may have costs directly associated with their service or product delivery.
The Gross Profit Margin holds a different weight with these businesses than it does with producers.
Gross Profit Drawbacks
Some drawbacks include:
-
Investors looking at the earnings of private companies should be aware of the cost and expense elements on a non-standardized income statement that may or may not be included in gross profit estimates.
-
Gross profit does not give a true picture of a company's financial performance because it overlooks all indirect expenditures, including wages, rent, electricity, advertising, and other relevant expenses.
-
Organizations' cost structures and profit calculations can vary, making the Gross Profit Margin only sometimes a good measure for comparing businesses.
-
It primarily analyzes the efficiency of a business. It ignores other factors, such as an increase in manufacturing costs to acquire a supplier or a decrease in the sale price to gain market share.
-
Profit figures calculated on a gross profit basis can be misleading. Because only production expenses are considered, inventory valuation techniques are required. The cost of materials, for example, can vary depending on inventory valuation methods like LIFO, FIFO, and weighted average.
Formula for Calculating Gross Profit
The formula is:
Gross Profit = Sales – Cost of Goods Sold
As an example:
A bicycle manufacturing company has sold 200 units for a total of $60,000 in sales revenue in the first quarter of the current year. It has, however, spent $25,000 on spare parts and materials and direct labor expenditures.
A total of $1,000 in returns from customers and allowances was also made. As a result, the first quarter's financial statement reported that it is $34,000 ($60,000 – $1,000 – $25,000).
Gross Profit Margin is a financial metric used to determine the profitability of a business operation. It demonstrates how successful sales can pay the direct costs of production.
Gross Margin = Gross Profit/ Total Revenue * 100
It is the formula for calculating the gross margin.
The gross margin is a percentage figure representing the portion of sales revenue that exceeds the cost of goods sold. For example, if a corporation has $500 million in revenue and $400 million in cost of goods sold, its gross margin is 20%.
The formula:
Net revenue = Sales – Return on Sales
Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
Gross Profit Examples
Consider the income statement below, which shows a corporation with $100,000 in revenue and $75,000 in cost of goods sold. The expenses computation would exclude any selling, general, and administrative expenses.
Let's take a few examples below:
To calculate the gross profit, subtract the cost of goods sold ($75,000) from revenue ($100,000) to get $25,000.
1. An automobile costs $500,000 to purchase. The owner is selling it for $600,000. Determine the Gross Profit Margin.
Ans.
Gross Profit = Revenue – Cost of Goods Sold
600,000 - 500,000 = 100,000
2. The firm's raw material costs are $10,000, labor costs are $2,000, and sales are $15,000. Determine gross profit.
Ans.
Cost of Goods Supplied = Raw Material + Labor Cost
= 10,000 + 2,000 = 12,000
Gross Profit = Total Sales – Cost of Goods Sold
= 15,000 – 12,000 = 3,000
3. Total sales are 60,000, and gross profit is 50,000. Calculate the Gross Profit Margin.
Ans.
Gross Profit Margin = (Gross Profit/ Total Sales or Revenue) * 100
= (50,000/ 60,000) * 100 = 83.33%
Let us take a look at example 2:
Here is an example of calculating the gross profit and Gross Profit Margin using Company ABC's income statement. It deals in automobiles.
| Revenues | (in USD millions) |
|---|---|
| Automotive | 141,546 |
| Financial services | 10,253 |
| Other | 1 |
| Total revenues | 151,800 |
| Costs and expenses | |
| Automotive cost of sales | 126,584 |
| Selling, administrative, and other expenses | 12,196 |
| Financial Services interest, operating, and other expenses | 8,904 |
| Total costs and expenses | 147,684 |
To determine the profit, add the cost of goods sold (COGS), which totals $126,584. We exclude selling, administrative, and other expenditures because they are largely fixed.
The gross profit is calculated by subtracting the cost of goods sold from revenue, yielding
$151,800 - $126,584 = $25,216 million
Then, we divide gross profit by total revenue to get the Gross Profit Margin, which is
$25,216 / $151,800 = 16.61%
Again, this compares well to the industry average of roughly 14%, indicating that ABC is more efficient than its competitors.
Gross Profit Importance
Gross profit is important when examining an entity's profitability and financial performance. This reveals how well the company uses its workers, raw materials, and other resources.
Several factors can affect a company's gross profit. The change in gross profit can be caused by the following:
-
Changes in the cost of items that contribute to higher prices
-
Cost-effective sales are the product of efficient business management.
-
Certain changes in accounting principles result in expenses being moved from the cost of sales to operating expenses or vice versa.
-
Vertical integration of business allows for low-cost raw material procurement.
For example, Wipro experienced a decrease in total revenues and gross profit in 2018. The following factors were the main culprits:
-
One of the communication segment's clients filed for bankruptcy, and several significant projects were scaled back.
-
Due to regulatory changes related to the Affordable Care Act, revenues from the Healthcare and Lifesciences verticals dropped.
As a result, gross profit is a crucial metric for understanding a company's financial health.
It assists in determining some fundamental reasons for a shift in the company's profitability. As a result, gross profit helps take corrective action in areas affecting a company's efficiency.
Gross Profit FAQs
Gross Profit is the difference between a company's sales and the cost of products sold (COGS). It is often used to assess how well a corporation manages labor and supplies in manufacturing. It measures the profitability of the firm.
Generally, it involves considering variable costs that fluctuate with production output. Labor, freight, and supplies are examples of these variable costs.
Gross Profit is the amount of money remaining after production costs are deducted from revenue, and it helps investors figure out how much money a firm makes from producing and selling its goods.
Net profit, also known as net income, remains after all expenses, including production costs, have been deducted from revenue. It demonstrates a company's overall profitability, which shows management effectiveness.
The monetary amount gained by selling goods and services to clients, excluding merchandise returned and any allowances/discounts granted to customers, is known as sales revenue. Net sales, on the other hand, refer to sales revenue minus returns and allowances.
Sales revenue can be generated through cash or credit sales.
The cost of goods sold, or "cost of sales," is a direct cost of producing a product. In addition, any raw materials and labor costs are included.
In a merchandising business, the cost is the actual amount of the finished product purchased from a manufacturer or supplier by a merchandiser. The cost of sales is calculated using an inventory account or a list of purchased raw materials or items.
or Want to Sign up with your social account?