What Is Gross Profit?
Gross profit is a company's profit after deducting the costs associated with producing and selling its products or services. It's also known as sales profit or gross income.
Gross profit is calculated on a company's income statement by subtracting the cost of goods sold (COGS) from total revenue. It's important to note that gross profit differs from operating profit, which is calculated by subtracting operating expenses from gross profit.
Key Takeaways
- Gross profit, also called gross income, is calculated by subtracting the cost of goods sold from revenue. The metric assesses a company's efficiency in using labor and supplies to produce goods or services.
- It typically includes variable costs, which fluctuate with production levels, but excludes fixed costs such as rent, insurance, and administrative expenses.
- Gross profit measures a company's profit on each sales dollar, after accounting for COGS. It's calculated as (Revenue - COGS) / Revenue x 100.
- Gross profit provides more controllable metrics than net profit, helping companies focus on product performance and apply cost control strategies more effectively.
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Formula for Gross Profit
Grossprofit=Netsales−CoGSwhere:Netsales=Equivalenttorevenue,orthetotalamountofmoneygeneratedfromsalesfortheperiod.Itcanalsobecallednetsalesbecauseitcanincludediscountsanddeduc-tionsfromreturnedmerchandise.Revenueistypicallycalledthetoplinebecauseitsitsontopoftheincomestatement.Costsaresubtractedfromrevenuetocalculatenetin-comeorthebottomline.CoGS=Costofgoodssold.Thedirectcostsassociatedwithproducinggoods.Includesbothdirectlaborcosts,andanycostsofmaterialsusedinproducingormanufacturingacompany’sproducts.
Calculating Gross Profit
Gross profit assesses a company's efficiency in using labor and supplies to produce goods or services. Unlike net income, gross profit doesn't include fixed costs - expenses that must be paid regardless of the output level. Fixed costs include items like rent, advertising, and insurance. Instead, gross profit focuses on variable costs that fluctuate with production levels, including:
- Materials
- Direct labor (assuming it's hourly or otherwise dependent on output levels)
- Commissions for sales staff
- Credit card fees on customer purchases
- Equipment (possibly including usage-based depreciation)
- Utilities for the production site
- Shipping
Under absorption costing, which is required for external reporting under generally accepted accounting principles (GAAP), a portion of fixed costs is assigned to each unit of production. For example, if a factory produces 10,000 widgets and pays $30,000 in rent for the building, a $3 cost would be attributed to each widget under absorption costing.
A company's gross profit will vary depending on whether it uses absorption or variable costing. Absorption costs include fixed and variable production costs in COGS, which can lower gross profit. Variable costing includes only variable costs in COGS, generally resulting in a higher gross profit since fixed costs are treated separately.
Gross Profit vs. Gross Profit Margin
Gross profit calculates the gross profit margin, a metric that evaluates a company's production efficiency over time. It measures how much money is earned from sales after subtracting COGS, showing the profit earned on each dollar of sales. Comparing gross profits year to year or quarter to quarter can be misleading since gross profits can rise while gross margins fall.
Although the terms are similar, gross profit differs from gross profit margin. Gross profit is expressed as a currency value, while gross profit margin is a percentage. The formula is:
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue x 100
Gross Profit vs. Net Income
Gross profit differs from net profit, also known as net income. While both are indicators of a company's financial health, they serve different purposes.
Gross profit is calculated by subtracting the cost of goods sold (COGS) from net revenue. Net income is calculated by subtracting all operating expenses from gross profit. Net income reflects the profit earned after all expenses, while gross profit focuses solely on product-specific costs.
Gross profit helps evaluate how well a company manages production, labor costs, raw material sourcing, and manufacturing spoilage. Net income assesses whether the operation is profitable, including administrative costs, rent, insurance, and taxes.
Net income is often called "the bottom line" because it resides at the end of an income statement. It refers to the company's total profit after accounting for all expenses, including operating costs, taxes, and interest.
Example of Gross Profit
| ABC Company - Income Statement | |
|---|---|
| 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 calculate the gross profit, we first subtract the cost of goods sold (COGS) from total revenue. COGS totals $126,584 million, while selling, administrative, and other fixed expenses aren't included. Subtract the COGS from revenue to obtain a gross profit of:
$151,800 - $126,584 = $25,216 million
To determine the gross profit margin, divide the gross profit by total revenues, for a margin of $25,216 / $151,800 = 16.61%. Most businesses have a gross profit margin that typically falls between 20% and 40%, although this varies significantly by industry.
Advantages of Using Gross Profit
Gross profit isolates a company's performance of the product or service it is selling. Removing the "noise" of administrative or operating costs allows a company to think strategically about product performance and implement cost control strategies more effectively.
Gross profit is also generally more controllable. Costs such as utilities, rent, insurance, or supplies are unavoidable and relatively fixed, while gross profit is dictated by net revenue and cost of goods sold. This means a company can strategically adjust more elements of gross profit than it can for net profit.
Limitations of Using Gross Profit
Standardized income statements prepared by financial data services may show different gross profits. These statements display gross profits as a separate line item, but they are only available for public companies. Investors reviewing private companies' income should familiarize themselves with the cost and expense items on a non-standardized balance sheet that may or may not factor into gross profit calculations.
While gross profit is a useful high-level gauge, companies often need to dig deeper to understand underperformance. For example, if a company's gross profit is 25% lower than its competitor's, it should investigate all revenue streams and each component of COGS to identify the cause.
Gross profit can also be misleading when analyzing the profitability of service sector companies. For example, a law office with no cost of goods sold will show a gross profit equal to its revenue. While gross profit might suggest strong performance, companies must also consider "below the line" costs when analyzing profitability.
What Does Gross Profit Measure?
Gross profit, or gross income, equals a company’s revenues minus its cost of goods sold (COGS). It is typically used to evaluate how efficiently a company manages labor and supplies in production. Generally speaking, gross profit will consider variable costs, which fluctuate compared to production output. These costs may include labor, shipping, and materials, among others.
What Is an Example of Gross Profit?
Consider the following quarterly income statement where a company has $100,000 in revenues and $75,000 in cost of goods sold. Under expenses, the calculation would not include selling, general, and administrative (SG&A) expenses. To arrive at the gross profit total, the $100,000 in revenues would subtract $75,000 in cost of goods sold to equal $25,000.
What Is the Difference Between Gross Profit and Net Profit?
Gross profit is the income after production costs have been subtracted from revenue and helps investors determine how much profit a company earns from the production and sale of its products. By comparison, net profit, or net income, is the profit left after all expenses and costs have been removed from revenue. It helps demonstrate a company's overallprofitability, which reflects the effectiveness of a company's management.
How Do You Calculate Gross Profit?
Gross profit is the difference between net revenue and the cost of goods sold. Total revenue is income from all sales while considering customer returns and discounts. Cost of goods sold is the allocation of expenses required to produce the good or service for sale.
The Bottom Line
By subtracting its cost of goods sold from its net revenue, a company can gauge how well it manages the product-specific aspect of its business. Gross profit helps determine whether products are being priced appropriately, whether raw materials are inefficiently used, or whether labor costs are too high. Gross profit helps a company analyze its performance without including administrative or operating costs.
Article Sources
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Sacremento State University. "Absorption/Variable Costing."
NYU Stern. "Margins by Sector (US)."
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