Gross Profit

Gross Profit: Meaning, Calculation & Benefits 

What is Gross Profit in eCommerce? Learn how to calculate it, as well as the benefits and limitations of using this metric to assess financial health.

When it comes to assessing performance in eCommerce, numbers reign supreme. This makes it crucial to understand various financial metrics to measure the success of an online business.

One of these important metrics is gross profit. It plays a crucial role in helping companies analyze their operational efficiency and profitability and dig deeper into their financial health.

What Is Gross Profit? 

Gross profit is a financial metric that represents the revenue a company earns from sales, minus the cost of goods sold (COGS). In other words, it is the profit that a company makes after accounting for the direct costs of producing or acquiring the goods or services it sells.

This metric primarily focuses on variable costs, which are expenses that fluctuate with the level of output. Some common examples of variable costs include:

• Materials
• Direct labor (assuming it's hourly or output-dependent)
• Sales staff commissions
• Credit card fees on customer purchases,
• Equipment costs (possibly including usage-based depreciation)
• Utilities for the production site
• Shipping expenses

Note that fixed costs, such as rent, office equipment, wages of non-sales staff, insurance, bank costs, and advertising, are not included in calculating the cost of goods sold figure when determining Gross Profit. This metric is typically found in the income statement section of a company's annual report.

How To Calculate Your Gross Profit 

To calculate the gross profit of a company the formula is as follows:

Gross Profit = Net sales - Cost of Goods Sold (COGS)

In addition to Gross Profit, it's also essential to compute the Gross Profit Margin, which gives a percentage representation of the Gross Profit relative to the total revenues:

Gross Profit Margin = (Gross Profit / Total Revenues) x 100

Let's illustrate the calculation with an example. Imagine a Company XY with a following income statement:

Revenues (in US$):

• Automotive: 300
• Financial services: 170
• Other: 30
• Total revenues: 500

Costs & expenses (in US$):

• Automotive cost of sales: 250
• Selling, administrative, & other expenses: 120
• Financial Services interest, operating, & other expenses: 80
• Total costs & expenses: 450

To calculate the Gross Profit, we add the COGS, which totals US$250. We exclude selling, administrative, and other expenses since these are primarily fixed costs. Subtracting the COGS from revenues gives:

Gross Profit = US$500 - US$250 = US$250

Gross Profit Margin = (US$250 / US$500) * 100 = 50%

Advantages of Using Gross Profit 

Understanding and utilizing Gross Profit can offer several advantages to companies, including:

• Controllability: The metric is influenced by two key factors – net revenue (driven by the price set by a company) and COGS (depending on the inputs a company pays for its product). Gross profit makes it easier for a company to manage profitability.
• Product or Service Performance Isolation: Gross Profit allows a business to isolate the performance of their product or service, meaning that a company can strategically assess how its products are performing and employ effective cost control strategies.
• Strategic Decision Making: The data from the metric can assist in decision-making by identifying areas of strength and weakness. It helps businesses refine their strategies and make informed decisions.

Limitations of Using Gross Profit 

Besides its numerous advantages, Gross Profit does have its limitations:

• Excludes Operating Expenses: Only direct production costs are considered in the calculation. Gross Profit does not account for operating expenses such as marketing, administrative costs, and taxes.
• Missing Financing Costs: Gross profit does not take into account interest expenses or financing costs, which are crucial for assessing the overall profitability and sustainability of a company.

Gross Profit: Key Takeaways 

• Gross profit is a financial metric that measures a company's profitability after accounting for the direct costs of producing or acquiring the goods or services it sells.
• To calculate gross profit, subtract the cost of goods sold (COGS) from net sales.
• Gross profit differs from gross profit margin, which is calculated by dividing gross profit by total revenues and multiply by 100.
• Gross profit is a measure of a company's profitability after accounting for the direct costs of producing or selling its products or services.
• It is a valuable metric for companies as it can provide insights into their product performance, cost structure, and strategic decision-making. However, it should be used in conjunction with other financial metrics to gain a comprehensive understanding of a company's financial health.