Every business needs to monitor its revenue, expenditure, and profits to ascertain its financial health and success. Gross profit is an important parameter that shows how much revenue a company brings after the subtraction of expenses involved with that revenue. This value tells the company’s management and investors the profitability of a certain product or service.
The following sections of this article will discuss the meaning of gross profit in more detail, as well as its calculation and differences from net profit.
What Is the Gross Profit of a Company?
A company’s gross profit is its gains made after the deduction of costs associated with the making and selling of its products or services. It is calculated as the revenue (sales) generated minus COGS (Cost of Goods Sold). Also called gross income or sales profit, it can be found in any company’s income statement.
Gross profits include only variable costs, such as the cost of materials, shipping, direct labour etc. and not fixed expenses such as rent, salaries paid, etc. Furthermore, this figure does not include indirect costs such as travel expenses, insurance, electricity charges and indirect revenue such as rent, commission and interest.
Gross profit should not be confused with operating profit, which is calculated by subtracting operating expenses from gross profit. It is also different from net profit, which is calculated as operating profit minus taxes and interest.
What Is the Formula for Calculating Gross Profit?
The gross profit formula is given as follows: Gross Profit = Total Revenue (or Sales) – Cost of Goods Sold (COGS).
In this formula, the total revenue refers to the money generated by a company after selling its goods within a specific period. Gross profit only includes variable costs and revenues involved in sales and production. It does not include the sale of any fixed assets, including a building or machinery, as these costs do not depend on the level of output.
For example, let’s say a clothing company gets Rs. 4,00,000 from the sale of garments and Rs. 20,00,000 by selling one of its stores. In this case, its total sales figure would be only Rs. 4,00,000 and not include the sale of fixed assets.
The company needs to add all its costs involved in the sale of garments to calculate the cost of goods sold. These costs are variable and depend on the total sales made. The following are some of the costs included for a clothing company:
- Cost of purchasing finished garments from wholesalers
- Salaries given to sales staff at its outlets
- Utility bills for its stores
- Cost of shipping the garments (for online sales)
- Commissions given to sales staff
How to Calculate Gross Profit with Example?
Let us take an example to illustrate how to calculate a company’s gross profit using the aforementioned formula:
ABC is an automobile company that generated Rs. 1.5 crore from the sale of vehicles and Rs. 12 lakh from financial services. It spent Rs. 85.8 lakh on acquiring its vehicles and Rs. 15 lakh on some vehicle parts. It has also spent Rs. 5.5 lakh on advertisements, Rs. 8 lakh on administrative expenses and Rs. 6.2 lakh on payment of interest for borrowings.
Its total revenue would be Rs. 1.62 crore while its COGS would be Rs. 1,00,80,000 (excluding administrative, marketing and financial expenses). Therefore, its gross profit would be —
Gross profit = Total revenue – COGS = Rs. 1,62,00,000 – Rs. 1,00,80,000 = Rs. 61,20,000
From the above data, ABC has generated Rs. 61.2 lakh in gross profits.
What is the Importance of Calculating Gross Profit?
The following are some important reasons for calculating gross profit:
- It indicates how efficiently a business uses its raw materials and supplies to produce goods or services at a profit.
- It is the goal of every business to be profitable. The management and investors need to know if a business sells its goods for more than what it spends on manufacturing them. Gross profit shows this value.
- A company’s gross profit ratio gives an understanding of its financial health. A company showing decent net profit may be declining if it’s not earning profits from its core activities, i.e., selling goods/services.
- Gross profit helps accountants and the management to calculate future forecasts and budgets for their company. Investors too can compare two or more companies of different sizes and sales volumes using this value.
- Profit margin calculated with gross profits tells if a business is cost-effective or not. A falling profit margin likely indicates overspending on production or lower selling prices. After figuring out the causes of low-profit margin a company’s management can take several steps to remedy this. It can renegotiate its pricing, trim labour costs, increase efficiency, or redo its purchasing policy to increase profitability
- One can use the company’s gross profit to calculate other important metrics such as gross profit margin and net profits. These give a more detailed explanation of a company’s profits.
Shortcomings of the Gross Profit Metric
A drawback of the gross profit method is that does not say everything about a company’s core business efficiency. Companies with large-scale production will have substantial gross profits regardless of their operating efficiency.
Another limitation of using only gross profit as an indicator of profitability. A company with higher gross profit does not necessarily have better financial health while one with lower gross profit may not have degrading financial health. Thus, one may want to take into account other expenses, taxes payable, advertisement costs etc. to calculate profitability.
What is Gross Profit Margin and How to Calculate It?
Gross Profit Margin measures a company’s efficiency over time. Unlike gross profit, which is presented as a currency value, the gross profit margin is expressed as a percentage. It is a better indicator of a company’s efficiency over a chosen time period.
Gross profit margin is a good yardstick for measuring how efficiently a company generates revenue from its products/services. Many companies utilise gross profit margin to compare against the industry average and see if it is below or above expectations.
The gross profit margin formula is as follows:
Gross Profit Margin = (Gross Profit/Total Revenue) x 100
For the ABC company mentioned above, the gross profit margin is computed below:
Gross Profit Margin = (Rs. 61,20,000/Rs. 1,62,00,000) x 100 = 37.78% (approx.)
Gross Profit vs Net Profit
Gross profit is the revenue left after costs directly related to the production of services or goods are subtracted. On the other hand, net profit is the amount calculated by subtracting the cost of producing goods and other expenses, including operating costs, interest, taxes etc., from total revenue.
When this amount is negative, the company has a net loss. Net profit is a more accurate number for profitability as it tells the exact amount of cash in hand for a company after paying all expenses.
Unlike gross profit, net profit includes fixed expenses such as administrative costs, marketing expenses, salaries, interest and general expenses. Another difference between gross profit and net profit is that the latter includes indirect expenses, including depreciation, rent, taxes, etc.
One can calculate net profits using the following formula:
Net Profit = Total Revenue – Total Expenses
For the example of ABC company, the calculation of net profit is as follows:
Net Profit = Rs. 1,61,00,000 – Rs. 1,20,50,000 = Rs. 40,50,000.
Final Word
Gross profit is the income left after subtracting the cost of goods sold from a company’s net sales. It shows how efficiently a company makes its profits based on its direct costs of production. It is an easy-to-use method to know the scale of revenue a company can generate against resources spent on production. One can also find out what operational expenses, liabilities and dividend distribution to reduce to get profitability.