Gross profit is the profit a company makes after deducting the costs associated with producing and selling its products or offering its services. It is also known 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 is different from operating profit, which accounts for operating expenses as well.
Key Takeaways
- Gross profit, also called gross income, is derived by subtracting the cost of goods sold from revenue.
- Generally, gross profit includes variable costs but excludes fixed costs.
- Gross profit evaluates a company’s effectiveness in utilizing labor and materials to produce goods or services.
Formula for Gross Profit
Gross profit = Net sales - COGS
where:
- Net sales = The total revenue generated from sales, inclusive of discounts and deductions from returned merchandise.
- COGS = Cost of goods sold, covering direct costs linked to the production of goods, including labor and materials.
Calculating Gross Profit
Gross profit is a reflection of a company’s efficiency in utilizing labor and materials to produce goods or services. It excludes fixed costs like rent and insurance that remain constant irrespective of output levels. The focus is solely on variable costs, such as materials, direct labor (assuming it’s paid hourly or is otherwise output-dependent), commissions for sales staff, credit card fees on customer purchases, production site utilities, and shipping.
Gross Profit vs. Gross Profit Margin
Gross profit serves as the basis for calculating the gross profit margin, a metric comparing production efficiency across different time periods. While gross profit is measured in currency value, the gross profit margin is expressed as a percentage:
Gross Profit Margin = (Revenue - COGS) \/ Revenue
Gross Profit vs. Net Income
Gross profit is distinct from net income, with the latter taking into account all operating expenses beyond production costs. Net income represents the total profit after subtracting all expenses, while gross profit focuses solely on the direct costs associated with the goods sold.
Example of Gross Profit
Consider the following example of an income statement for ABC Company:
| 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, subtract the cost of goods sold ($126,584 million) from total revenues ($151,800 million):
Gross Profit = $151,800 - $126,584 = $25,216 million
Advantages of Using Gross Profit
Gross profit isolates the financial performance related to the products or services sold, helping companies strategize around these specific areas. It is also more controllable compared to net profit which includes relatively uncontrollable costs like rent and insurance.
Limitations of Using Gross Profit
Standardized income statements can vary, possibly showing different gross profits. Public companies generally provide standardized income statements, while private companies may not always have clear separate line items for costing and expenses. A comprehensive examination of both revenue streams and COGS components is necessary for a deeper understanding.
What Does Gross Profit Measure?
Gross profit measures a company’s efficiency in production by considering variable costs only. It reflects how effectively a company uses labor and supplies in production.
The Bottom Line
By subtracting the cost of goods sold from net revenue, gross profit helps gauge how well a company manages the product-specific aspects of its business without accounting for administrative or operating costs. It helps determine if products are priced appropriately, raw materials are used prudently, or labor costs need adjustment.
Related Terms: net income, gross profit margin, operating profit, cost of goods sold, financial metrics, business finance.
