What is a Gross Profit?

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Definition:

Gross profit is the money that remains after a business deducts from its revenue the costs directly related to producing its product or service.

🤔 Understanding gross profit

Gross profit is the revenue from sales minus the costs directly related to making those sales. Gross profit appears on a company’s income statement. Gross profit may also be referred to sometimes as gross income or sales profit. To arrive at a gross profit number, a company would deduct the value of the raw materials used to make the product sold as well as the cost of paying the laborers who created the product. These expenses are referred to as the cost of goods sold (COGS). Of course, there are many other expenses that a business might incur — for example, office utility bills, insurance, and advertising expenses — but they are not considered part of COGS, and thus would not be part of the gross profit calculation.

Example

Imagine that Lucy makes the best lemonade on her block. Last summer, her lemonade stand saw a sales revenue of $50. To discover her gross profit, we must subtract the cost of the goods that Lucy’s Luxurious Lemonade used to make its product.

Let’s say that Lucy spent $10 for lemons and $5 for sugar — and assume these are her only costs of goods sold (since she’s not counting her labor). Her gross profit is her sales revenue minus her COGS. So Lucy’s Luxurious Lemonade saw a gross profit of $35 ($50 - $15 = $35).

Takeaway

Gross profit is like your profit as a pizza delivery driver…

Delivering pizzas gets you paid through wages and tips (revenue). But to figure out your gross profit, you’ll have to subtract the cost of goods sold (COGS) from your revenue — In this case, the cost of the gasoline it took to drive to all of your delivery locations. What remains is your gross profit. Just as you wouldn’t consider the cost of your car in this calculation, a business doesn’t include sunk costs in calculating its gross profit.

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What is gross profit?

Gross profit is the amount of money a business makes from selling a product or service after the company subtracts the amount of money it spent creating that product or providing the service. The gross profit gives a more accurate indication of a company’s sales success than sales figures alone can provide.

For example, suppose that one year a company reports $100M in sales. When it subtracts the costs associated with the product (let’s say $60M), it earned a gross profit of $40M ($100M - $60M = $40M).

In contrast, the next year, the company reports $150M in sales. At first glance, you may assume the company must have experienced a tremendous boost in earnings. The gross profit, on the other hand, tells a different story. The costs related to the product skyrocketed to $120M. When the company subtracted its costs from its revenue ($150M - $120M = $30M), it was left with less than it had earned the previous year.

The items deducted from the sales revenue to achieve the gross profit are collectively referred to as the cost of goods sold (COGS). The items included in the COGS can vary from industry to industry and company to company. Not only do companies have some leeway regarding which items they include as part of their COGS, but they can also use different costing methods to calculate material costs and allocations. This means COGS can vary widely even among competing companies in the same business sector.

However, the COGS is likely to include such things as:

  • Any raw materials and inventory used to produce the products sold
  • Direct labor to make the materials or provide the services

Depending on the accounting method used, it may also include expenses such as factory overhead and freight.

What is the difference between gross profit and gross margin?

Gross profit is expressed in an amount while gross margin, also known as gross profit margin, is stated as a percentage. Suppose a company made $25M in sales. After deducting $5M in costs, the company has a gross profit of $20M ($25M - $5M = $20M).

To find the gross margin, divide the gross profit by the sales revenue, and then multiply by 100 to convert the number into a percentage. In this case, the sales revenue is $25M. So, divide the gross profit of $20M by $25M. The company had an impressive 80% gross margin (($20M / $25M) x 100).

What is the difference between gross profit and net profit margin?

Gross profit represents the money a company has left after it subtracts the costs related to producing that product or service. Net profit takes it a step further and accounts for all expenses –- It tells you what your bottom line profit is after subtracting all of your period costs, including items such as rent, administration, utilities, depreciation, and taxes.

Just as gross profit margin is the gross profit expressed as a percentage of sales, net profit margin is your net profit expressed as a percentage of sales.

Let’s look at a company’s gross profit and then compare it to the net profit margin. Let’s say a small high-end clothing boutique had $4M in sales revenue last year. To produce its clothing line, it spent $3M in fabric and labor. The boutique’s gross profit is $1M ($4M - $3M = $1M). But what’s the store’s net profit margin?

To determine the net profit margin, we begin with the gross profit and then subtract operating expenses and all other expenses. The costs that we are now subtracting are those that were not accounted for when calculating the gross profit.

A clothing boutique’s operation expenses might include retail rental fees, staff payroll, insurance, and marketing. Additional costs would be things such as depreciation, taxes, and interest on outstanding debts.

We’ll say that the store’s operating expenses and other expenses total $600,000. We then subtract $600,000 from the gross profit of $1M to reach $400,000 in net profit.

We now divide the net profit by total sales revenue ($400,000 / $4M = .10).To calculate a net profit margin, multiply .10 by 100. The clothing boutique’s net profit margin is 10%. In other words, for each dollar the store received in sales, it was able to keep 10 cents or 10% as net profit.

What is a good gross profit margin?

The gross profit margin will differ significantly from one type of business to another. Companies with low production costs are likely to post larger gross profit margins.

For example, cable television companies don’t typically have to pay factory production costs, enormous shipping costs, or huge inventory fees. As a result, one gross profit margin survey found that cable TV companies enjoyed a gross profit margin average of 61.38%. In contrast, the same poll showed the automobile industry operating with a gross profit margin average of only 11.45%. Source: New York University, Leonard N. Stern School of Business, January 2019.

A good gross profit margin is, therefore, dependent upon the circumstances. In general, however, you might be safe in assuming that a good gross profit margin is one that’s in step with the industry average during good economic times.

How do you calculate gross profit?

The formula for calculating gross profit is: Revenue – Cost of Goods Sold (COGS) = Gross Profit.

Gross profit can be found in a company’s income statement. If it’s not, or you simply want to calculate it yourself, you can use the equation above. Revenue (or sales) is generally the first line on a company’s income statement. Their Cost of Goods Sold (COGS) should be listed next, although they may be classified under another name, such as Cost of Sales.

What are the limitations of using gross profit?

Gross profit is only the company’s first level of profit. It gives you a basic idea of how efficiently a company can produce a sale. However, it doesn’t give you the complete picture.

The gross profit does not reflect the total cost of operations, as it does not deduct any additional costs, such as administrative expenses and interest on outstanding debts.

If you want to know a company’s true profitability, you must subtract all the remaining costs from the gross profit. What remains will be the net profit — a more accurate indication of how well an enterprise is functioning.

A company could be reporting what seems to be a healthy gross profit and still losing money. For instance, if a company has $20M in gross profit but $25M in operating expenses, it’s losing $5M every period.

Gross profit can also be misleading for comparing businesses with significantly different costs or different accounting practices. Typically gross profit will vary widely between industries, especially if you’re trying to compare a service company (which would usually have low costs of production) with a business that provides manufactured goods (such as an automobile company). It can also vary between similar companies simply based on how they account for their costs of goods sold. Gross profit is only one number –- In order to understand the true health of a company, more information is needed.

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