Definition of Gross Profit
A company's gross profit is determined by deducting the cost of products and services sold from revenue generated by those sales. In accounting terms, the formula for gross profit is "total revenue minus cost of goods sold (COGS)." Regardless of the size of a business enterprise, gross profit is an important measure in evaluating a business' operating efficiency and helps internal and external stakeholders identify and remedy problems.
Other People Are Reading
-
Direct and Indirect Costs
-
Since the calculation of gross profit considers only costs that are directly attributable to generating revenues, it follows that gross profit gives an idea only of how much a company would earn if it did not incur indirect costs, such as factory overhead, salaries, taxes, utilities and supplies. For example, if a company sold merchandise costing $1,000 for $1,500, its gross profit would be $500. This amount, however, is not what the company earns, as the indirect costs outlined above are not included in the cost of the sale.
Gross and Net Profit
-
Gross profit can be used to calculate net profit, which is what the business earns over a period. In calculating net profit, all costs are deducted from all revenues -- in other words, net profit is found by subtracting indirect costs that are not directly attributable to making sales, from gross profit. Both gross and net profit amounts are important figures for management. If gross profit is too low, it signifies that either the company sells products or services too cheaply or acquires them at too high a cost. If net profit is too low, it means the company incurs high costs in day-to-day operating.
-
Gross Profit Margin
-
Gross profit margin, or gross margin, is a percentage that shows the proportion of income made from revenues after considering cost of goods sold. Acceptable gross profit margins may vary from industry to industry and company to company. In general, for two similar-size companies operating in the same region and industry, the one with the higher gross profit margin is operating more efficiently, because the company is better able to convert investment to profit. The formula for gross profit margin is "(revenue minus COGS) divided by revenue."
Comparison
-
Gross profit margin is compared to that of competitors and the industry average to evaluate where the particular business stands within the industry. Investors and lenders may review the figures to identify operational inefficiency and management problems. When comparing figures between different entities, the method used to calculate gross margin must be the same for all entities to maintain consistency and enable the best comparison. A company may perform gross profit comparisons between different departments internally, to deduce which departments are performing well and which departments require investigation.
Trend Analysis
-
Trend analysis is the practice of comparing figures over time. In performing trend analysis, the individual or group analyzing the business compares the gross profit margin of the company with the gross profit margin for a base year. Comparing to a base year gives a benchmark to better appreciate changes in the profit margin. For example, if the base year is 2007 and the current year is 2010, the gross profit margin figures for the two years will be compared, and any changes will be investigated. An increase in the value may mean that the company is more efficient in acquiring merchandise, and a decrease may mean that revenue from sales has dropped.
-
References
- Photo Credit graph toys image by Florin Capilnean from Fotolia.com
