Explanation of Gross Profit
Gross profit is one of the baseline facts used to calculate a company's fiscal health. It is a simple figure that can show how much profit potential a company has but does not determine a company's profitability by itself. It is possible to make a sizable gross profit but still be in the red.
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Identification
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To calculate gross profit, you take the amount of product sales and subtract the cost of making the product. For example, a widget sells for $10 and costs $4 to make. The gross profit is $6. In this example, since $6 out of every $10 is profit, the gross profit margin is 60 percent. Generally, the higher the gross profit margin, the better.
Overhead
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Gross profit is only part of the overall profitability picture. There may be a great deal of associated business costs, or overhead, that are not a direct part of the production cost of a product. Management and administrative salaries, marketing and advertising, security measures, customer service, quality control, shipping and transportation, capital costs and taxes are just some of the business costs that can eat up gross profit.
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Net Profit
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True profitability cannot be determined without adding overhead costs in. It may cost you $4 to make your widget, but it also costs you $1 to market and advertise it, customer service and quality control costs you another dollar and shipping costs 50 cents. That does not include other overhead costs that take yet another dollar. Your total overhead adds another $3.50 per widget, so your profit margin has dropped to $2.50 per widget. That is your net profit.
Corporate Profitability
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Net profit is total business revenue minus all business costs. You can find the net profit on each item by dividing the net profit by the number of items sold. If a business is still in the black, then it is truly operating at a profit. Many new businesses are not. They may make a gross profit, but are paying heavy short-term start-up costs. While they are a profitable business on paper, in reality they are operating at a loss and will until the start-up costs are recouped.
Corporate Losses
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A company has to make a gross profit if they stand any chance at profitability. If the cost of making a product costs more than it can sell for, the product is a loss. Sometimes companies will introduce a new product line at a loss or low gross profit to generate interest in it. Other times they may do so to attract interest in their other products, such as a sale item to get new customers into a store, where they will likely buy additional items at a profit. This kind of promotional product is called a "loss leader."
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References
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