Gross profit is one of several key profitability metrics that help companies evaluate their financial health. It is necessary to determine gross profit before you can calculate other important figures such as net profit, EBITDA, and the company’s bottom line. Gross profit indicates how well a business is doing at earning income while managing costs and productivity.
What Is Gross Profit?
A company’s gross profit refers to the total revenue a business earns over a given accounting period minus the direct costs associated with earning that revenue.
Revenue refers to the income received from regular business operations. In most cases, revenue is the money generated by sales of goods and/or services. It is often called the “top line” figure because it is the first entry on a company’s income statement.
Cost of Revenue includes the operational cost of products and services sold, as well as the expenses directly related to making the sale of those products and services. In a business that sells physical goods, the cost of revenue generally refers to Cost of Goods Sold (COGS). Overhead costs not directly related to sales, such as payroll taxes, building rental, and administrative expenses, are not generally included in the cost of revenue.
Gross profit can be calculated using the following formula:
Gross Profit = Revenue – Cost of Revenue
If a business has an increase in revenue over an accounting period or production costs decrease, there will be a higher gross profit for that period than the period before. However, if production costs increase or revenues decrease, the gross profit will be lower.
For instance, suppose a company experiences an increased demand for its products over the holiday season. This will lead to an increase in revenue. However, it may also require hiring temporary workers, paying overtime wages to existing employees, and/or increasing efficiency to meet the demand. Gross profit helps determine the best balance to maximize profitability.
Why Gross Profit Is Important?
Gross profits are important because the analysis helps companies optimize the performance of their company. Gross profit figures, evaluated over time, help a company determine how well it is managing its costs and marketing its products. A decline in gross profit may indicate a serious problem that needs to be addressed. An increase may show that recent changes are working and should be continued or enhanced.
For Example:
Suppose your company brought in $100,000 in revenue last month. Your cost of revenue was $60,000. Therefore, your gross profit is:$100,000 – $60,000 = $40,000
Now we compare against the previous month, where revenue was $90,000 and cost of revenue was $40,000. The gross profit for that quarter was:$90,000 – $40,000 = $50,000
There seems to be a problem here. Even though revenue increased during the most recent accounting period, your company’s gross profit went down substantially. If this was unexpected, it may indicate a need to cut costs or increase productivity.
Limitations of Gross Profit
Gross profit is best used as a metric for measuring company progress over time. Taken by itself, it reveals little other than the scale of operations. It does not facilitate a comparison between companies or analysis of overall company efficiency. Gross profit is just one of several financial figures that need to be taken into account.
Gross Profit vs. Net Profit
To determine whether the company made or lost money, the financial advisor needs to consider overhead expenses and other costs not directly associated with production.
Gross profit recognizes only the cost of goods sold. These are variable costs directly related to the production and sales of products and services. Net profit refers to the profit remaining after all expenses are taken into account.
Net profit includes operating expenses, sometimes called overhead costs, as well as interest, taxes, etc. These are fixed costs that are not directly related to production. Some of these expenses may include administrative salaries, rent, insurance, utilities, and taxes.
For instance, in the example above, suppose that last month your company’s overhead expenses included $5,000 for building rental, $10,000 for management salaries, and $5,000 for utilities. That makes $20,000 in additional expenses. Subtracting these expenses from gross profit, your net profit is:$40,000 – $20,000 = $20,000
In the previous month, let’s say you had the same expenses plus a $5,000 legal bill. The net profit for that month was:$50,000 – $20,000 – $5,000 = $25,000
Other Metrics Calculated from Gross Profit
Gross income can be calculated from gross profit by adding in other sources of revenue not related to products and services. These may include such things as donations, grants, rental income, gains or losses from asset sales, royalties, and investment gains or losses.
Gross Income = Gross Profit – Operating & Miscellaneous Expenses
Gross profit margin or also referred to as Margin is a percentage or ratio that may be calculated for individual products or for the company as a whole. The formula for calculating gross profit margin is:
Gross Profit Margin = Gross Profit ÷ Sales
Net income, often referred to as the “bottom line,” takes into account all revenue and all expenses from the accounting period.
Net Income = Gross Profit + Other Income – Operating & Miscellaneous Expenses
Once net income has been calculated, it is possible to calculate EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This is a measure of profitability often used to help investors analyze a company’s financial performance.
EBITDA = Net Income + Interest + Taxes + Depreciation expenses + Amortization expenses
In Summary
Gross profit is an important part of a company’s income statement. It helps measure the company’s ability to balance revenue generation with operational efficiency over time. It facilitates other important calculations that measure the overall health of a business.
If you have questions about this or other financial topics, we invite you to visit preferredcfo.com or talk with one of our CFOs.
