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The definition of gross profit is the difference between a company’s revenue and cost of goods sold (COGS). In other words, it is the profit that remains after deducting all the direct costs associated with producing a product or providing a service. Gross profit can be used to measure the efficiency and productivity of the business as well as identify potential areas of improvement.
Gross profit is the profit a company makes after deducting the costs associated with the production and sale of its products or the costs associated with the provision of its services. Gross profit appears on a company’s income statement and can be calculated by subtracting cost of goods sold (COGS) from revenue (sales). This data can be found in the company’s income statement. Gross profit may also be referred to as profit on sales or gross income.
Gross profit can be used to calculate another metric – gross profit margin. This metric is useful for comparing a company’s manufacturing performance over time. Simply comparing gross margins from year to year or from quarter to quarter can be misleading, as gross margins can increase while gross margins decrease – a troubling trend that can lead a company into trouble. 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 and gross profit margin as a percentage.
Gross profit is different from net profit, also called net income. While both are indicators of a company’s financial ability to generate sales and profit, these two measurements have completely different purposes.
Gross profit is calculated by subtracting the cost of goods sold from net revenue. Then, subtracting the company’s other operating expenses, net income is obtained. Net income is the profit earned by the enterprise after accounting for all costs, while gross profit accounts only for product-specific costs of goods sold. Since these are two different calculations, they have completely different purposes for evaluating how a company is doing. Gross profit is useful to determine how well a company manages its production, labour costs, raw material supply and spoilage. Net income is useful to determine, in general, whether an enterprise’s operations are profitable after accounting for overhead, rent, insurance, and taxes.
Here’s an example of calculating gross profit and gross profit margin using ABC Company’s income statement.
To calculate gross profit, we must first add up the cost of goods sold (COGS), which totals $126,584. We do not include selling, administrative and other expenses as these are primarily
fixed costs. We then subtract cost of goods sold from revenue to arrive at a gross profit of USD 151 800 – USD 126 584 = USD 25 216 million.
To obtain the gross profit margin, we divide the gross profit by the total revenue and obtain a margin of USD 25,216 / USD 151,800 = 16.61%. This compares favourably with the automotive industry average of around 14%, suggesting Ford is operating more efficiently than its peers.
There are several reasons why a company would want to analyze gross profit versus net profit. There are several reasons why a company would want to analyze gross profit versus net profit. By removing the “noise” of administrative or operational costs, a company can think strategically about how its products perform or implement better cost control strategies.
Furthermore, gross profit is usually more controllable than other aspects of the company. Consider costs such as utilities (for office operations), rent, insurance, or supplies Some of these costs are unavoidable in the course of business and relatively uncontrollable in terms of costs incurred. On the other hand, gross profit is determined by net revenue (which is largely determined by the price set by the company) and the cost of goods sold (which is largely determined by the inputs the company pays for its product). A company can strategically change more components of gross profit than net profit; therefore, it makes sense to sometimes limit management’s view primarily to what it can control.
Limitations of the Use of Gross Profit The standardized income statements prepared by financial data services may give slightly different gross profits. These reports conveniently
show gross profit as a separate line, but they are only available for public companies. Investors who review the earnings of private
companies should familiarise themselves with the cost and expense items in the non-standardised balance sheet that may or may not be involved in gross profit calculations.
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