What Is Gross Profit?
Gross profit is the profit a company makes after deducting the costs associated with producing and selling its products or the costs associated with its services. Gross profit may also be referred to as sales profit or gross income.
Gross profit appears on a company's income statement and is calculated by subtracting the cost of goods sold (COGS) from revenue or sales. Gross profit should not be confused withoperating profit. Operating profit is calculated by subtracting operating expenses from gross profit.
Key Takeaways
- Gross profit, also called gross income, is calculated by subtracting the cost of goods sold from revenue.
- Gross profit commonly includes variable costs and not fixed costs.
- Gross profit assesses a company's efficiency in using labor and supplies to produce goods or services.
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Formula for Gross Profit
Grossprofit=Netsales−CoGSwhere:Netsales=Equivalenttorevenue,orthetotalamountofmoneygeneratedfromsalesfortheperiod.Itcanalsobecallednetsalesbecauseitcanincludediscountsanddeduc-tionsfromreturnedmerchandise.Revenueistypicallycalledthetoplinebecauseitsitsontopoftheincomestatement.Costsaresubtractedfromrevenuetocalculatenetin-comeorthebottomline.CoGS=Costofgoodssold.Thedirectcostsassociatedwithproducinggoods.Includesbothdirectlaborcosts,andanycostsofmaterialsusedinproducingormanufacturingacompany’sproducts.
Calculating Gross Profit
Gross profit assesses a company's efficiency in using labor and supplies to produce goods or services. Gross profit does not include fixed costs or costs that must be paid regardless of the level of output. Fixed costs include items like rent, advertising, and insurance. The metric looks at variable costs that fluctuate with the level of output, such as:
- Materials
- 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
- Shipping
However, a portion of fixed costs is assigned to each unit of production under absorption costing, required for external reporting under the generally accepted accounting principles (GAAP). If a factory produces 10,000 widgets, and the company pays $30,000 in rent for the building, a cost of $3 would be attributed to each widget under absorption costing.
A company's gross profit will vary depending on whether it uses absorption costing or variable costing.
Gross Profit vs. Gross Profit Margin
Gross profit is used to calculate another metric, the gross profit margin. This metric compares 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.
Although the terms are similar, gross profit differs from gross profit margin. Gross profit is expressed as a currency value, and gross profit margin as a percentage.The formula for gross profit margin is:
GrossProfitMargin=RevenueRevenue−CoGSwhere:CoGS=CostofGoodsSold
Gross Profit vs. Net Income
Gross profit is different from net profit, also known as net income. Though both are indicators of a company's financial ability to generate sales and profit, these two measurements serve different purposes.
Gross profit is calculated by subtracting the cost of goods sold from net revenue. Net income is then calculated by subtracting the remaining operating expenses of the company. Net income is the profit earned after all expenses have been considered, while gross profit only considers product-specific costs of the goods sold.
Gross profit helps determine how well a company manages its production, labor costs, raw material sourcing, and spoilage due to manufacturing. Net income helps determine 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.
Example of Gross Profit
| ABC Company - Income Statement | |
|---|---|
| Revenues | (in USD millions) |
| Automotive | 141,546 |
| Financial services | 10,253 |
| Other | 1 |
| Total revenues | 151,800 |
| 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, the cost of goods sold (COGS) totals $126,584 million. Selling, administrative, and other expenses are not included since they are fixed costs. Subtract the cost of goods sold from revenue to obtain a gross profit of:
$151,800 - $126,584 = $25,216 million
To obtain the gross profit margin, divide the gross profit by total revenues for a margin of $25,216 / $151,800 = 16.61%. This compares favorably to an assumed automotive industry average of 14%.
Advantages of Using Gross Profit
Gross profit isolates the 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 perform or employ greater cost control strategies.
Gross profit is also generally more controllable. Costs such as utilities, rent, insurance, or supplies are unavoidable during operations and relatively uncontrollable. Gross profit is dictated by net revenue and cost of goods sold. A company can strategically alter more components of gross profit than it can net profit.
Limitations of Using Gross Profit
Standardized income statements prepared by financial data services may show different gross profits. These statements 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 high levels, gross profit is a useful gauge, but a company will often need to dig deeper to better understand why it is underperforming. If a company discovers its gross profit is 25% lower than its competitor's, it may investigate all revenue streams and each component of COGS to understand why its performance is lacking.
Gross profit can also be a misnomer when considering the profitability of service sector companies. A law office with no cost of goods sold will show a gross profit equal to its revenue. Gross profit may indicate a company is performing exceptionally well but must be mindful of the "below the line" costs when analyzing gross profit.
What Does Gross Profit Measure?
Gross profit, or gross income, equals a company’s revenues minus its cost of goods sold (COGS). It is typically used to evaluate how efficiently a company manages 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. Under expenses, the calculation would not include 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 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 left after all expenses and costs have been removed from revenue. It helps demonstrate a company's overallprofitability, which reflects 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 manages the product-specific aspect of its business. Gross profit helps determine whether products are being priced appropriately, whether raw materials are inefficiently used, or whether labor costs are too high. Gross profit helps a company analyze its performance without including administrative or operating costs.
