Gross profit is the money a company earns after subtracting the costs associated with producing and selling its products. The gross profit is represented as a whole dollar amount, showing the revenue earned after subtracting the costs of production.
Companies calculate gross profit by subtracting the costs directly related to the production of their goods or cost of goods sold from their revenue. Gross profit measures how well a company generates profit from their labor and direct materials.
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 are subtracted to achieve net income or the bottom line.
Cost of goods sold or COGS is the direct costs associated with producing goods. COGS includes both direct labor costs, and any costs of materials used in producing or manufacturing a company's products. Some types of labor costs are included in the cost of goods sold, while others are not.
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 for the company 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. This is why sometimes you'll see net sales listed as the top line on an income statement in place of revenue, particularly with retailers.
After a product is returned, the company not only has a reduction in sales but on top of that, the company subtracts the original cost of the item from the cost of goods sold account. This means that a sales return does have an impact on gross profit.
For more on gross profit, please read "How Do Gross Profit and Gross Margin Differ?"