What Is A Gross Profit?
Gross Profit shows the earnings of the business entity from its core business activity, i.e., the company’s profit that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc., from the direct income generated from the sale of its goods and services.
Gross profit percentage and its ratio are two key indicators that the investors look at in the Compan’s income statementCompan's Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. These provide a view of the financial performance of the Company. As in, the efficiency with which they manage the demand and supply of the goods and the variable costs associated with the production and sales of the goods.
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Gross Profit Explained
Gross profit is the amount made by the Company after deducting the costs of goods soldDeducting The Costs Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. or the costs associated with the services the Company has provided. It is available on an income statement before deducting selling, general and administrative expenses (SG&A), non-operating revenues, non-operating expenses, other gains, and other losses.
However, businesses use gross profit margin to assess their performances as the gross profit figure could be the exact same while the gross profit margin could be on a decline. Therefore, it could be deceiving for the owners and management to analyze their business based on just gross profit.
Moreover, the overall profits of the organization can only be determined after the calculation of net profit, which calculates all direct and indirect costs before determining the amount remaining after all such expenses.
The formula to use the gross profit calculator is as discussed below:
This formula only considers variable costs. Variable costs are the cost to the Company that varies with the output. It should be noted that fixed costs are not considered when deducting the cost of goods sold from the revenue to calculate it.
Variable Costs include the following items:
- Raw Materials
- Packaging costs
- Freight costs
- Sales commissionsSales CommissionsSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission.
Examples of Gross Profit
How To Calculate?
Let us take a company and its financials to help us calculate the gross profit percentage.
A Company has a revenue of $ 50000, and its cost of goods sold was $ 30000. What is the gross income of the CompanyGross Income Of The CompanyThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity.?
GP =$50,000 – $30,000
The GP will be –
- GP = $ 20000
Let us understand the concept of gross profit percentage through the examples below. This shall give us an in-depth understanding of the concept.
A Company in Auto manufacturing has the following items on its profit and loss statement. Calculate Gross Profit using the following data.
|Revenue from Sales
|Cost of Goods
|Selling, Administrative Expenses
|Interest and Financial Expense
Selling and administrative expenses will not be added to the cost of goods since they are mostly fixed costs. Also, interest and financial expenses will not be added to the metric as they represent interest paid to the financers.
- $ 75000
GP Ratio will be –
Therefore, Gross Profit Ratio = 62.5%
For FY 2015, GP = $16034 – $6,635 = $9,399.
Let us now calculate the Gross Profit Margin.
- The cost of Operations includes the Depreciation related to manufacturing operations (Colgate 10K 2015, pg 63).
- Shipping and handling costs may be reported in the Cost of Sales or Selling General and Admin Expenses. Colgate reported these as a part of Selling General and Admin ExpensesSelling General And Admin ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc..
- If such expenses are included in the Cost of Sales, the Gross Ratio of Colgate would have decreased by 770 bps from 58.6% to 50.9% and decreased by 770bps and 750 bps in 2014 and 2013, respectively.source: – Colgate 10K 2015, pg 46
Every business wants to increase their gross profit percentage as it indicates the absolute returns from their sales. Let us understand the two major methods through which GP can be increased through the discussion below.
#1 – Increase the price of products
The increasing price of products may decrease the number of products sold and thus, decrease the revenue as the customers will prefer buying a competitor product at a lower price. Therefore, the price increase should be done by considering the product’s inflation, competition, demand, supply, quality of the product, and USP (unique selling point).
#2 – Decrease the cost of products
Variable costs can decrease by decreasing the inputs of the goods, i.e., raw material, or by the production of goods efficiently. The company can get discounts by purchasing raw materials in bulk from the supplier. Raw material costs can be decreased by purchasing material from a supplier that provides products at a cheaper rate. However, it may hamper the quality of the product. The Company can maintain or reduce costs by producing the goods efficiently.
Gross Profit Vs Net Profit
The use of a gross profit calculator gives basis for the calculation of net profit. However, these two terms appear most often while determining the profitability of an organization. Let us understand the difference between them through the comparison below.
- Gross profit is the amount remaining after subtracting all direct expenses in the manufacturing process. It is used to determine the profitability of the company.
- It shows a credit balance on a trading account.
- It is challenging to make financial decisions as GP does not cover factors such as taxes, other expenses, and loan interests.
- It only makes sure no extra costs are incurred in the manufacturing process.
- Net profit is the leftover profit after all outstanding expenses of an organization are met within a financial period. It determines the company’s overall performance.
- It is the absolute profit of the organization based on which, they can make financial decisions for the growth of the company.
- It shows a credit balance on the profit and loss statement.
- It indicates the yearly performance of the company which can be compared with previous years for performance comparison.
This article has been a guide to what is Gross Profit. Here we explain its formula, how to calculate, examples, and methods in detail. You can learn more about accounting from the following articles –