Gross Profit (Definition, Examples) | How to Calculate Gross Profit Ratio?

What is Gross Profit?

Gross profit is the amount of profit made by the Company after deducting the costs of goods sold or the costs associated with the services the Company has provided. It is available on an income statement prior to deducting selling, general and administrative expenses (SG&A) and non-operating revenues, non-operating expenses, other gains, and other losses.

Gross Profit Formula

It is calculated as below:

Gross Profit Formula = Revenue – Cost of goods sold

This gross profit formula only considers variable costs. Variable costs are the cost to the Company that varies with the output of the Company. It should be noted that the fixed costs are not considered when deducting the cost of goods sold from the revenue to calculate it.

Variable Costs include the following items:

Materials
Labour
Packaging costs
Freight costs
Sales commissions
Depreciation expenses on machinery and production equipment

Calculating Gross profit Ratio

The Gross Profit Ratio formula can be represented as –

Gross Profit Ratio Formula = Gross Profit / Revenue

It measures the profitability of the Company. Many Companies see an increase in profit but a decrease in gross profit ratio and hence they may face financial difficulty in the near future due to declining profitability.

Examples of Gross Profit and Ratio

Let’s calculate gross profit and ratios for the following examples.

Example #1

A Company has a revenue of $ 50000 and its cost of goods sold was $ 30000. What is the gross income of the Company?

Solution:

GP =$50,000 – $30,000

GP will be –

GP = $ 20000

Example #2

A Company in Auto manufacturing has following items on its profit and loss statement. Calculate Gross Profit Ratio using the following data.

Selling and administrative expenses will not be added to the cost of goods since they are mostly fixed cost. Also, interest and financial expenses will not be added to the metric as they represent interest paid to the financers.

Gross Profit

$ 75000

Gross Profit Ratio will be –

Therefore, Gross Profit Ratio = 62.5%

Gross Profit (GP) Calculation of Colgate

Let us calculate Colgate’s GP

Colgate’s GP = Net Sales – Cost of Sales.

For FY 2015, GP = $16034 – $6,635 = $9,399.

Let us now calculate the Gross Profit Ratio.

Cost of Operations includes the Depreciation related to manufacturing operations (Colgate 10K 2015, pg 63).
Shipping and handling costs may be reported in Cost of Sales or Selling General and Admin Expenses. Colgate reported these as a part of Selling General and Admin Expenses.

If such expenses are included in Cost of Sales, then 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

Methods to Increase the Gross Profit Ratio

It can be increased by two methods:

#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. Price increase should be done by taking into account the inflation, competition, demand, and supply of the product, quality of the product and USP (unique selling point) of the product.

#2 – Decrease the cost of products

Variable costs can decrease by a decrease in the inputs of the goods i.e. raw material or by production of goods efficiently. By purchasing raw material in bulk from the supplier, the Company can get discounts. Raw material costs can be decreased by purchasing material from a supplier which provides products at a cheaper rate, however, it may hamper the quality of the product. The Company can maintain or reduce cost by producing the goods efficiently.

Conclusion

GP is revenue or total sales minus the cost of goods sold. Cost of goods sold is the variable cost of the goods which is basically the cost that varies with the number of goods.

Gross profit and its ratio are two key indicators that the investors look in the Companies income statement. These provide a view on the financial performance of the Company and how well it manages the demand and supply of the goods and manage the variable costs associated with the production and sales of the goods.

Gross Profit