Gross profit is the amount the business remains with after deducting the cost of providing its services or making and selling its products. Gross profit is normally reflected on a company’s income statement and is calculated by reducing the cost of goods sold from the sales.
The term “gross profit” is sometimes interchanged with gross income or sales profits.
A business analyzes gross profit to find out how efficiently it’s using its supplies and labor to produce and sell products or services. The gross profit captures variable costs – costs that vary depending on the level of production and sales. They include things such as:
- Direct labor
- Cost of materials
- Shipping costs
- Commissions to the salespeople
- Utilities directly used in the production process, etc.
Gross Profit is calculated as follows:
Formula: Gross Profit = Revenue − Cost of Goods Sold
Gross profit does not capture other costs including fixed costs such as rent and salaries since they’re not directly attributed to production. Still, a section of the other fixed costs is linked to product costs under a concept called absorption costing, as required by the generally accepted accounting principles (GAAP). If, for example, a business produces and sells 1,000 bicycles in a given month and rent for the period amounts to $2,000, each unit of the bicycle will have an additional cost of $2 for rent.
Gross profit should never be confused with operating profit, which is profit after calculating tax. Operating profit is attained after deducting operating expenses from gross profit. Operating expenses are things like salaries, admin expenses, rent, utilities, and so on.
How Gross Profit Works
To further help you understand your business gross profit, consider this sample income statement for a motor vehicles company:
|Revenues||In USD 000|
|Costs and Expenses|
| Less: Cost of sales|
(labor, materials, etc.)
Other expenses will then be deducted from the gross profit until the final net profit after tax is attained.
But what is a good gross profit margin? To answer that, you must first understand the gross profit margin.
What is a gross profit margin?
A gross profit margin is a financial metric used to analyze a company’s financial health by subtracting the sales from the cost of goods sold. It is always expressed as a percentage of the net sales.
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
From the example above, the Gross Profit Margin is as follows:
(620,000 – 200,000) / 620,000= 68%
This means that the company’s products attract a gross profit margin of 68%.
So, in closing, what is a good profit margin?
A good gross profit margin varies from industry to industry. That notwithstanding, as a general rule of thumb, a net profit margin of 10% is considered average, 20% is considered “good”, while above 21% is considered excellent.