Gross Profit: Meaning & Definition
In the complex eCommerce, where numbers reign supreme, understanding various financial metrics is essential for business success. One of those important metrics is gross profit.
This metric plays a crucial role in helping companies assess their operational efficiency and profitability. It allows businesses to dig deeper in the financial health of their company.
What Is a 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's 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:
- direct labour (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
- and 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 you a percentage representation of your Gross Profit relative to your 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:
- 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 up 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 u:
Gross Profit = US$500 - US$250 = US$250
Meaning, Gross Profit Margin = (US$250 / US$500) * 100 = 50%
Advantages & Limits of Using the Gross Profit
All in all, understanding and utilizing Gross Profit can offer several advantages to companies, here are some examples:
- Controllability: Since the metric is influenced by two the key factors, net revenue (driven by the price set by a company) and COGS (depending on the inputs a company pays for its product), the gross profit makes it for a company more controllable, and thus, a significant advantage in managing 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 of the metric can provide strategic decision-making, by identifying based on this data areas of strength and weakness, helping businesses refine their strategies and make informed decisions.
Besides its numerous advantages, Gross Profit does have its limitations:
- Excludes Operating Expenses: Only direct production costs are considered in the calculation, while the 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
To conclude, gross profit is an important financial metric that can be used by businesses to measure their performance and identify areas for improvement.
- 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. It is calculated by subtracting the cost of goods sold (COGS) from the net sales, while Gross profit is typically found in the income statement section of a company's annual report.
- To calculate gross profit, subtract the cost of goods sold (COGS) from net sales, not to confuse with the 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 to track, 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.