Gross Profit is the income a business has left after paying all direct expenses related to a product’s manufacturing. Gross Profit = Revenue – Cost of Goods Sold.
Here’s What We’ll Cover:
- What is the formula for gross profit in a business operation?
- What is Gross Profit Margin?
- Why Is Gross Profit Important?
- Gross profit vs. net profit
What is the formula for gross profit in a business operation?
The gross profit formula is:
Gross profit = Sales Revenue – Cost of Goods Sold
As of the first quarter of business operation for the current year, a bicycle manufacturing company has sold 200 units, for a total of $60,000 in sales revenue. However, it has incurred $25,000 in expenses, for spare parts and materials, along with direct labor costs. There were also returns and allowances for a total of $1,000. As a result, the gross profit declared in the financial statement for Q1 is $34,000 ($60,000 – $1,000 – $25,000).
What is Sales Revenue?
Sales revenue or net sales is the monetary amount obtained from selling goods and services to customers – excluding merchandise returned and any allowances/discounts offered to customers. This can be realized either as cash sales or credit sales.
What is the Cost of Goods Sold?
Cost of goods sold, or “cost of sales”, is an expense incurred directly by creating a product. It includes any raw materials and labor costs incurred. However, in a merchandising business, cost incurred is usually the actual amount of the finished product (plus shipping cost if any) purchased by a merchandiser from a manufacturer or supplier. In any event, cost of sales is properly determined through an inventory account or through a list of raw materials or goods purchased.
What is Gross Profit Margin?
A business owner cannot simply measure the amount of gross profit on jobs to gauge which jobs are the most profitable. The best way to look at your profitability is to track gross profit margin, which is gross profits as a percent of revenue. Gross margin percent (typically not found on an income statement) is calculated as follows.
(Gross Profit divided by Revenue) X 100 = Gross Profit Margin %
($1,500,000 / $4 million) x 100 = 37.5%
Looking at gross margin percentage is the best way to track profitability of a job. That’s because while your income may be growing, your gross profit could be shrinking. You won’t recognize that fact unless you see the relationship between the two as a percentage.
Why Is Gross Profit Important?
Gross profit is important for a company’s accounting because it deals specifically with the cost of goods sold. In other words, the data generated can reflect how efficient a company’s management is when it comes to the purchasing of supplies, allocation of labor or decisions regarding the plant or location where the product is being produced.
Gross profit vs. net profit
The biggest difference between gross profit and net profit is the subtraction of expenses. While gross profit is the value of the revenue generated overall after only subtracting the operational costs or the cost of providing a product or service, the net profit describes the total amount a business keeps after gross revenue, overhead expenses and other indirect expenses are subtracted from the earnings. A company may use gross profit and net profit to evaluate its overall financial health and standing.
Knowing the difference between calculating gross profit and net profit can be essential in situations where a business is reviewing its financial performance. A business can use its net profit to determine whether it has incurred a loss or gained a profit. Gross profit, conversely, can tell a company how sales are performing.
The difference between gross and net profit also means a business can determine where its financial health stands. For instance, if you encounter a negative result in your net profit, it means your business has incurred a net loss. You can then use information from the data to make changes to marketing or sales strategies. Knowing that gross profit is the total value before all other expenses are deducted also means you can implement budgeting strategies to ensure your financial goals are met.