Gross profit (GP) is what a company makes after taking out the costs of making and selling its products or services. You might also hear it called sales profit or gross income.
To figure out gross profit, you look at the income statement and subtract the cost of goods sold (COGS) from the total revenue. Just keep in mind that gross profit isn’t the same as operating profit, which is found by taking operating expenses out of it.
Calculate Gross Profit
Gross profit = Net sales − CoGS
where:
CoGS=Cost of goods sold. It looks at how well a company uses its workforce and materials to create products or services. It’s different from net income because it doesn’t take into account fixed costs, which are expenses that need to be paid no matter how much is produced. Fixed costs cover things like rent, advertising, and insurance.
Example
Check out this quarterly income statement: the company raked in $100,000 in revenue while its cost of goods sold was $75,000. When looking at expenses, we’re not counting selling, general, and administrative (SG&A) costs. To figure out the gross profit, you simply take the $100,000 in revenue and subtract the $75,000 in cost of goods sold, which leaves you with a GP of $25,000.
Pros of GP
It focuses on how well a company is doing with the products or services it offers. By filtering out the distractions of administrative and operating expenses, businesses can take a clearer look at product performance and develop better cost management strategies.
Additionally, gross profit tends to be easier to manage. Expenses like utilities, rent, insurance, and supplies are pretty much set in stone, while GP is influenced by net revenue and the cost of goods sold. This gives companies more flexibility to tweak various aspects of gross profit compared to net profit.
Cons of GP
Standardized income statements from financial data services can show varying gross profits. These statements list gross profits as a distinct line item, but they’re only accessible for public companies. Investors looking at private companies’ income should get to know the costs and expenses on a non-standardized balance sheet, as these might influence gross profit calculations.
While gross profit is a handy overall indicator, companies often need to dig deeper to figure out why they might be underperforming. For instance, if a company’s GP is 25% lower than that of a competitor, it should take a closer look at all its revenue sources and each part of COGS to pinpoint the issue.
It can also be a bit misleading when assessing the profitability of service-based companies. Take a law firm, for example, which has no cost of goods sold; its GP will match its revenue. Even if GP seems to indicate strong performance, companies need to factor in “below the line” costs to get a complete picture of profitability.
Conclusion
A company can figure out how well it’s handling the product side of things by taking its net revenue and subtracting the cost of goods sold. Gross profit gives insights into whether products are priced right, if raw materials are being wasted, or if labor costs are getting out of hand. It allows a business to assess its performance without factoring in administrative or operating expenses.