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.
Understanding Gross Profit
Gross profit assesses a company's efficiency at using its labor and supplies in producing goods or services. The metric mostly considers 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
The formula for gross profit is:
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, also known as earnings before interest and tax (EBIT), which is a company's profit before interest and taxes are factored in. Operating profit is calculated by subtracting operating expenses from gross profit.
- Also called gross income, gross profit is calculated by subtracting the cost of goods sold from revenue.
- 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 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 margin 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 margin=Revenue(Revenue−Cost of goods sold)
Example of How to Use Gross Profit
Here is an example of how to calculate gross profit and the gross profit margin, using Ford Motor Co.'s 2018 annual 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, 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.
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 do and don't factor into gross profit calculations.