Gross profit is the money a company earns after subtracting the costs associated with producing and selling its products or services. The gross profit is represented as a whole dollar amount, showing the revenue earned after subtracting a company's cost of goods sold or cost of services in the case of a company producing and selling services.
Cost of goods sold (COGS), or or cost of services (COS) for a service-related business, represents the costs directly related to the production of a company's goods. Direct labor costs are part of cost of goods sold or cost of services as long as the labor is directly tied to production. As a result, direct costs are factored into gross profit through COGS or COS. However, not all labor costs are included in COGS. In this article, we explore the relationship between gross profit, cost of goods sold, cost of services, overhead, and labor costs.
Components of Gross Profit
Revenue is the total amount earned from sales for a particular period. For some industries, net sales may be used in place of revenue because net sales include deductions from returned merchandise and any discounts. Revenue is the top line on the income statement whereby costs, expenses, and other items are subtracted to achieve net income or the bottom line.
Cost of goods sold or COGS, or cost of services (COS), is the direct costs associated with producing goods. COGS/COS includes both direct labor costs, and any direct costs of materials used in producing or manufacturing a company's products. Direct costs could include raw materials, inventory, as well as the costs associated with equipment used in production.
Some types of labor costs are included in cost of goods sold, while others are not. Cost of goods sold is subtracted from revenue to arrive at gross profit. In short, gross profit measures how well a company generates profit from their labor and direct materials.
- Gross profit is the money a company earns after subtracting the costs associated with producing and selling its products or services.
- The gross profit is calculated by subtracting a company's cost of goods sold from its revenue.
- Overhead costs are not included in gross profit, except possibly overhead that's directly tied to production.
- Only direct labor, involved in manufacturing a company's goods, is included in cost of goods sold or cost of services and ultimately gross profit.
What Are Overhead Costs?
Overhead includes all ongoing business expenses, not including or related to direct labor or direct materials used in creating a product or service. A company must pay overhead on an ongoing basis, regardless of how much or how little the company is selling. Most overhead expenses are relatively consistent from month to month, and many can be fixed. Some examples include rent and utilities.
Manufacturing overhead or factory overhead is the overhead or indirect costs associated with manufacturing a product. For example, electricity for a factory would be included in COGS when determining the cost of producing a product. Just like direct materials costs that are part of COGS, so too must manufacturing overhead be included in the costs of goods sold and ultimately impacts gross profit.
Non-manufacturing overhead costs, on the other hand, are administrative costs and are not considered product costs, according to GAAP. Therefore non-manufacturing costs do not directly impact gross profit calculations. However, when pricing goods for sale, there needs to be enough markup to cover overhead costs, and so indirectly, they are captured in gross profit.
Only direct labor involved in production is included in gross profit. As stated earlier, factory overhead, including labor, might be included but will be assigned a cost per product. Administrative costs such as secretaries and accountants, legal positions, janitorial workers, analysts, and other non-production jobs would not have their wages included in cost of goods sold.
Gross profit does not take into account the overall taxes paid by the company. However, it's important to note that property taxes for a manufacturing plant would be included in manufacturing overhead. In other words, a portion of the property tax on the factory would be assigned to each product when determining the cost of goods sold.
The tax assigned to each product is not used in the gross profit calculation but is embedded in COGS and indirectly impacts gross profit. The overall taxes that are not directly tied to production would be listed separately and deducted when calculating net income or the net profit for the company.
Sales returns impact revenue and cost of goods sold, ultimately affecting gross profit. Whenever a product is returned, and the customer is reimbursed, it gets recorded in an account called sales returns and allowances.
When companies have returns, they must calculate net sales, which is revenue minus sales returns and allowances. The result, or net sales, is recorded at the top line of the income statement in place of revenue, which is typical for retailers.
Example of Gross Profit, COGS, and SG&A
Below is the income statement of the U.S. automobile manufacturer, Tesla Inc. (TSLA). The period represents Q2 of 2019, according to the company's 10-Q report.
- Cost of revenue (or COGS), which is highlighted in red, shows the company incurred approximately ~$5.4 billion in cost of revenues in Q2 2019—a jump from 2018's ~$3.3 billion.
- Gross profit, which is highlighted in green, was ~$921 million for Q2 2019, which was higher than the ~$618 million for the same period in 2018.
- Sales, general, and administrative expenses, which are highlighted in blue, came in at $647 million in Q2 2019 versus $750 million in Q2 of 2018.
We can see that SG&A was listed under operating expenses and not included in gross profit. The breakdown of the company's costs on the income statement is important in determining where profitability exists and where it does not.
For Tesla, we can see that although the company generated a gross profit, the company reported a loss in both periods. The loss is reflected in the net income line item (the bottom line) whereby Tesla reported a -$389 million loss for Q2 2019 and a -$742 million loss for Q2 2018.
Tesla's income statement illustrates how overhead costs, as well as other operating expenses, can impact a company's profitability. Also, the cost of debt, shown as interest expense, was a contributing factor in the company's loss in both periods. In short, a company that reports an increase in gross profit doesn't necessarily mean the company is more profitable.
Conversely, if a company is spending a significant amount of its cash and borrowings on research and development, it might report a loss for the quarter under net income. However, gross profit might tell a different story, showing an increasing trend of profitability.
Gross profit is typically used with companies like Tesla that need to invest significant sums in R&D, which should lead to profitability in the long term. As with any financial metric, gross profit and the costs of a company should be compared to other companies within the same industry.