Gross profit is the revenue earned by a company after deducting the direct costs of producing its products. The direct labor and direct material costs used in production are called cost of goods sold.
Gross profit is the result of subtracting a company's cost of goods sold from total revenue. As a result, depreciation and amortization are not usually included in the calculation of gross profit.
However, it's important to note that there are situations when depreciation is recorded in cost of goods sold and can impact gross profit. Below, we explore how gross profit is calculated and how depreciation and amortization may or may not impact a company's profitability.
Components of Gross Profit
Before exploring how depreciation and amortization impact profit, we should first review the two main components of gross profit: revenue and cost of goods sold.
Revenue is the total amount of income generated from sales in a period. Revenue is also called net sales because discounts and deductions from returned merchandise may have been deducted.
Cost of goods sold is the direct costs associated with producing a company's goods. Cost of goods sold or COGS includes both direct labor costs and any costs of materials such as raw materials used in producing a company's products.
Gross profit measures how effectively a company generates profit from its direct labor and direct materials. Gross profit does not include non-production costs. Only the costs and profit associated with the production facility or factory are included in gross profit. Some of these costs include the following:
- Direct materials
- Direct labor
- Equipment costs involved in production
- Utilities for the production facility
- Shipping costs
As stated earlier, gross profit is calculated by subtracting COGS from revenue. For example, if it costs $15,000 in production costs to manufacture a car, and the car sells for $20,000, the difference of $5,000 is the gross profit on that one car.
- Gross profit is the revenue earned by a company after deducting the direct costs of producing its products.
- The direct labor and direct material costs used in production are called cost of goods sold (COGS).
- Typically, depreciation and amortization are not included in cost of goods sold and are expensed as separate line items on the income statement.
- However, a portion of depreciation on a production facility might be included in COGS since it's tied to production—impacting gross profit.
Depreciation and Amortization
As stated earlier, in most cases, depreciation and amortization are treated as separate line items on the income statement.
Depreciation is typically used with fixed assets or tangible assets, such as property, plant, and equipment (PP&E). Depreciation is a method of allocating the cost of an asset over its expected useful life. Instead of recording the purchase of an asset in year one, which would reduce profits, businesses can spread that cost out over the years, allowing them to earn revenue from the asset.
Amortization is similar to depreciation but is used with intangible assets, such as a patent. Amortization spreads out capital expenses of intangible assets over a specific time frame—typically over the useful life of the asset.
Both depreciation and amortization are accounting methods designed to help companies recognize expenses over several years. The expense reduces the amount of profit, allowing a company to have a lower taxable income. Since depreciation and amortization are not typically part of cost of goods sold—meaning they're not tied directly to production—they're not included in gross profit.
Example of Gross Profit, Depreciation, and Amortization
Below is a portion of the income statement for the former J.C. Penney Company Inc. as of May 4, 2019.
- Total revenue is highlighted in green for the amount of $2.55 billion, while the COGS is beneath revenue, coming in at $1.63 billion.
- Depreciation and amortization of $147 million are listed separately, highlighted in yellow.
- For J.C. Penney, gross profit for the period would include revenue and COGS. Depreciation and amortization would not be used in the gross profit calculation, but instead would be included in the calculation of operating income. J.C. Penney's operating income for the quarter came in at -93 million or a loss.
The source of the depreciation expense determines whether the expense is allocated between cost of goods sold or operating expenses. Some depreciation expenses are included in the cost of goods sold and, therefore, are captured in gross profit.
For example, the depreciation of the building for the corporate office and its furniture would not be included in COGS because it's not a direct cost associated with the production of goods. However, a portion of depreciation on the manufacturer's plant or facility would be included in the overhead costs or fixed costs for the plant. As a result, that portion of depreciation might also be included in COGS because the depreciation is directly tied to the factory.
It is much more rare to see amortization included as a direct cost of production, although some businesses such as rental operations may include it. Otherwise, amortized expenses are typically not captured in gross profit. Accounting treatment on income statements varies somewhat for each business and by industry.