Gross Profit - Explained
What is Gross Profit?
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Table of ContentsWhat is Gross Profit?How does Gross Profit Work? Example of Gross ProfitAcademic Research on Gross Profit
What is Gross Profit?
The gross profit of a business, variously referred to as its sales profit or gross income, is the total profit that it makes from sales after deducting the costs associated with producing and selling its products or delivering its services. In simpler terms, the gross profit is net sales minus the cost of goods sold (COGS). Gross profit figures are typically denoted on the income statement of the business, and are mathematically represented as, Gross Profit = Net Sales Revenue - COGS, where, COGS = cost of goods sold.
How does Gross Profit Work?
Gross profit is typically indicated on an income statement prior to deducting expenses (such as general expenses, administrative expenses and sales expenses) and before factoring in non-operating revenues, non-operating expenses, as well as gains or losses. It is a reliable indicator of the efficiency of a business in optimally utilizing its labor and raw material supplies in producing goods or delivering services. However, such a standard of measurement only takes into account variable costs such as the cost of materials, labor costs, sales commissions, various fees levied on customer purchases, cost of equipment, cost of utilities consumed during production, and shipping costs. As such, gross profit excludes from the calculation, fixed costs such as costs associated with rent or lease of assets, advertising costs, insurance premiums paid, and salaries for non-production staff such as employees associated with human resources, housekeeping and security. Nevertheless, generally accepted accounting principles (GAAP) directives mandate that businesses assign a part of the fixed costs to each unit of production for external reporting purposes. Such a requirement is mandated under the absorption costing methodology endorsed by GAAP. Gross profit is essentially a measure of the ability of a business to utilize its machinery, labor and raw materials to their full potential during the production of finished goods or services. However, such a metric only evaluates variable costs, i.e. corporate expenses that fluctuate according to the output of production. The various variable costs can be classified as follows:
- Costs of raw materials.
- Labor costs, especially those that consist of hourly payment terms (also known as billable staff wages) or are dependent on the levels of output (also known as peice rate labor).
- Costs associated with production supplies.
- Cost of equipment, usually accounting for usage-based depreciation.
- Costs associated with utilities at the production site.
- Shipping or freight costs.
- Credit card fees chargeable to the business for customer purchases.
It should be noted that calculations of gross profit do not include fixed costs since such costs will have to be paid irrespective of the levels of output. Fixed costs typically consist of rent associated with property or assets, costs associated with the purchase of stationery and office supplies, advertising expenses, insurance premiums payable, as well as remunerations paid in the form of salaries of employees not typically associated with the core production process (e.g. employees belonging to human resources, payroll or security). That said, certain fixed overhead costs are allocated across all units under the concept of absorption costing a requirement mandated by the generally accepted accounting principles (GAAP) for external reporting. For example, assume that an automobile manufacturer produces 1,000 pickup trucks in a month and pays $20,000 in rent for the property and various other assets. Under absorption costing, an additional cost of $20 would be allocated to each pickup truck produced during that month. Gross profit can be further used to determine the gross profit ratio, which is obtained by dividing gross profit by net sales revenue, and the result expressed as a percentage. Mathematically, Gross Profit Ratio (GPR) = Gross Profit / Net Sales Revenue. i.e. Gross Profit Ratio = (Net Sales Revenue - COGS) / Net Sales Revenue. Gross profit is fundamentally different from operating profit, which is a measure of the company's profit before interest and taxes are included in the calculation. Popularly referred to as earnings before interest and tax (EBIT), operating profit is calculated by subtracting operating expenses from gross profit. Operating profit = Gross profit - Operating expenses.
Example of Gross Profit
Let us assume that manufacturer M has recorded net sales revenue worth $100,000, while its cost of goods sold (COGS) for the same period using absorption costing is $40,000. Ms gross profit can be calculated as follows. Gross Profit = $100,000 - $40,000 = $60,000. Furthermore, the gross profit can now be used to calculate Ms gross profit ratio as follows: Gross Profit Ratio = $60,000 / $100,000 = 60%.