Gross profit is an important measure of a company's profitability that indicates its ability to turn a dollar of revenue into a dollar of profit, after accounting for all expenses directly associated with producing goods or services for sale. Gross profit is simply total revenue minus the cost of goods sold, or COGS.
COGS is a very specific financial concept that includes only those business expenses required to produce goods, such as raw materials and wages for labor required to create or assemble the product. Other expenses required to run a business, such as rent and insurance premiums, are not included. COGS is comprised of fixed costs and variable costs, which in turn have a large effect on gross profit.
What Are Variable Costs?
Variable costs are expenses that increase or decrease according to the number of items produced. For example, to produce 100 rocking chairs, a company may need to purchase $2,000 worth of lumber. To produce 1,000 rocking chairs, lumber needs are much greater, making this a variable cost. When a company reduces its variable costs, gross profit margin should increase as a result.
Other variable costs include wages for direct labor, shipping costs, and sales commissions.
What Are Fixed Costs?
Fixed costs are expenses that do not change based on production levels. This does not mean these expenses are written in stone – sometimes rent goes up or insurance premiums go down. Instead, the term "fixed" applies to the absence of a relationship between the amount of the expense and the number of items produced. Whether the company makes 100 rocking chairs or 1,000, rent is paid for use of the factory or warehouse either way.
Other common fixed cost expenses are advertising costs, payroll for salaried employees, payroll taxes, employee benefits, and office supplies.
Determining Cost of Goods Sold
It is clear from the definition of fixed versus variable costs that the COGS figure is comprised of both types of expenses. Some businesses consider COGS to include all variable expenses, leaving all fixed expenses to be accounted for under overhead costs. A more realistic approach is to include any costs directly associated with the production of goods regardless of category.
Common variable costs included in the COGS figure are the cost of raw materials, other supplies necessary for production, wages for labor required to produce goods and utilities for the facility where production occurs. Common fixed costs included in the COGS calculation are salaries for supervisory employees required to ensure product quality and equipment depreciation costs.
How Fixed and Variable Costs Affect Gross Profit
Both fixed and variable costs have a large impact on gross profit and on its more comprehensive counterpart, operating profit. An increase in the expenses required to produce goods for sale means a lower gross profit. This is important because without a healthy gross profit, a robust net profit, the all-encompassing bottom line, is unlikely.
Gross profit is the first measure of profitability on a company's income statement, and all further profitability metrics trickle down from this figure. Companies, therefore, look to reduce fixed costs and variable costs to bolster profits at every level.