What Is Gross Profit?
Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Gross profit will appear on a company's income statement and can be calculated by subtracting the cost of goods sold (COGS) from revenue (sales). These figures can be found on a company's income statement. Gross profit may also be referred to as sales profit or gross income.
- Gross profit, also called gross income, is calculated by subtracting the cost of goods sold from revenue.
- Generally, gross profit only includes variable costs and does not account for fixed costs.
- Gross profit assesses a company's efficiency at using its labor and supplies in producing goods or services.
- Gross profit, which only reflects the cost of goods sold, is different than net profit which factors in all company-wide expenses.
- A derivative of gross profit is gross margin, a margin that indicates what percent of revenue a company earns can be applied towards company operating costs.
Formula for Gross Profit
Gross profit=Net sales−CoGSwhere:Net sales=Equivalent to revenue, or thetotal amount of money generated from salesfor the period. It can also be called net salesbecause it can include discounts and deduc-tions from returned merchandise. Revenueis typically called the top line because it sitson top of the income statement. Costs aresubtracted from revenue to calculate net in-come or the bottom line.CoGS=Cost of goods sold. The direct costsassociated with producing goods. Includes bothdirect labor costs, and any costs of materialsused in producing or manufacturing a company’sproducts.
What Gross Profit Can Tell You
Gross profit assesses a company's efficiency at using its labor and supplies in producing goods or services. The metric mostly looks at variable costs—that is, costs that fluctuate with the level of output, such as:
- Direct labor, assuming it is hourly or otherwise dependent on output levels
- Commissions for sales staff
- Credit card fees on customer purchases
- Equipment, perhaps including usage-based depreciation
- Utilities for the production site
As generally defined, gross profit does not include fixed costs (that is, costs that must be paid regardless of the level of output). Fixed costs include rent, advertising, insurance, salaries for employees not directly involved in the production, and office supplies.
However, it should be noted that a portion of the fixed cost is assigned to each unit of production under absorption costing, which is required for external reporting under the generally accepted accounting principles (GAAP).
For example, if a factory produces 10,000 widgets in a given period, and the company pays $30,000 in rent for the building, a cost of $3 would be attributed to each widget under absorption costing.
Gross profit shouldn't be confused with operating profit. Operating profit is calculated by subtracting operating expenses from gross profit.
A company's gross profit will vary depending on whether it uses absorption costing (required for external reporting) or variable costing (disallowed for external reporting but useful for internal reporting).
Gross Profit vs. Gross Profit Margin
Gross profit can be used to calculate another metric, the gross profit margin. This metric is useful for comparing a company's production efficiency over time. Simply comparing gross profits from year to year or quarter to quarter can be misleading, since gross profits can rise while gross margins fall—a worrying trend that could land a company in hot water.
Although the terms are similar (and sometimes used interchangeably), gross profit is not the same as gross profit margin. Gross profit is expressed as a currency value, gross profit margin as a percentage. The formula for gross profit margin is as follows:
Gross Profit Margin=RevenueRevenue−CoGSwhere:CoGS=Cost of Goods Sold
Gross Profit vs. Net Income
Gross profit is different from net profit, also referred to as net income. Though both are indicators of a company's financial ability to generate sales and profit, these two measurements have entirely different purposes.
Gross profit is calculated by subtracting cost of goods sold from net revenue. Then, by subtracting remaining operating expenses of the company, you arrive at net income. Net income is the profit earned by a business after all expenses have been considered, while gross profit only considers product-specific costs of that goods that have been sold.
Because these are two different calculations, they have entirely different purposes for gauging how a company is doing. Gross profit is useful to determine how well a company is managing its production, labor costs, raw material sourcing, and spoilage due to manufacturing. Net income is useful to determine overall whether a company's enterprise-wide operation makes money when factoring in administrative costs, rent, insurance, and taxes.
Net income is often referred to as "the bottom line" because it resides at the end of an income statement. Alternatively, gross profit is often the third line to the top on an income statement (underneath net revenue and cost of goods sold).
How to Calculate Gross Profit
Here is an example of how to calculate gross profit and the gross profit margin, using Company ABC's income statement.
|Revenues||(in USD millions)|
|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 add up the cost of goods sold (COGS), which sums up to $126,584. We do not include selling, administrative and other expenses since these are mostly fixed costs. We then subtract the cost of goods sold from revenues to obtain a gross profit of $151,800 - $126,584 = $25,216 million.
To obtain the gross profit margin, we divide the gross profit by total revenues for a margin of $25,216 / $151,800 = 16.61%. This compares favorably to an automotive industry average of around 14%, suggesting that Ford operates more efficiently than its peers.
Advantages of Using Gross Profit
There's a few reasons why a company would want to analyze gross profit as opposed to net profit. Gross profit isolates performance of the product or service it is selling. By stripping away the "noise" of administrative or operating costs, a company can think strategically about how its products are performing or employ greater cost control strategies.
Gross profit is also generally more controllable than other aspects of a company. Consider costs such as utilities (for office operations), rent, insurance, or supplies Some of those expenses are unavoidable during the course of business and relatively uncontrollable in regards to the expenses incurred
On the other hand, gross profit is dictated by net revenue (largely driven by the price set by a company) and cost of goods sold (largely driven by the inputs a company pays for its product). A company can strategically alter more components of gross profit than it can net profit; therefore, there is value in sometimes limiting management's view to primarily what it can control.
Limitations of Using Gross Profit
Standardized income statements prepared by financial data services may give slightly different gross profits. These statements conveniently 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.
At a high level, gross profit is useful; however, a company will often need to dig deeper to better understand why it is underperforming. For example, imagine a company discovers its gross profit is 25% lower than its competitor. While gross profit is useful in identifying an issue, the company must now investigate all revenue streams and each component of cost of goods sold to truly understand why its performance is lacking.
Gross profit can also be a misnomer, especially when consider the profitability of service sector companies. Consider a law office with no cost of goods sold. In this example, the law office's gross profit is equal to its revenue. However, the rent expense of the company office is twice as high as monthly rent. Gross profit may indicate a company is performing exceptionally well, but be mindful of the "below the line" costs when analyzing gross profit.
What Does Gross Profit Measure?
Gross profit, also known as gross income, equals a company’s revenues minus its cost of goods sold (COGS). It is typically used to evaluate how efficiently a company is managing 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. Importantly, under expenses, your calculation would not include any 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 that is left 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 that is left after all expenses and costs have been removed from revenue. It helps demonstrate a company's overall profitability, which reflects on 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 is managing the product-specific aspect of its business. This calculation of gross profit helps determine whether products are being priced appropriately, whether raw materials are being inefficiently used, or whether labor costs are too high. In general, gross profit helps a company analyze how it is performing without including administrative or operating costs.