Gross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company 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 is referred to as the gross profit of the business.
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.
Formula
It is calculated as below:
This 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 formula can be represented as –
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 the 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
GP Ratio will be –
Therefore, Gross Profit Ratio = 62.5%
Gross Profit (GP) Calculation of Colgate
Let us calculate Colgate’s GP
- 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.
Recommended Articles
This has been a guide to what is Gross Profit, its definition and formula. Here we discuss how to calculate Gross Profit ratio along with practical examples and ways to increase the same. You can learn more about accounting from the following articles –
- Cost of Sales Formula Overview
- Top 12 Most Common Examples of Fixed Cost
- Profit and Loss Statement Template in Excel
- (Selling, General & Administrative) SG&A Expenses
- Calculate Depreciation Expense
- Calculate Profit Margin
- Calculate Gross Profit Margin
- Calculate Unit Contribution
- Compare Profit and Income
