What Is Gross Profit and How Is It Calculated in Financial Statements?

Gross profit represents the revenue remaining after deducting the cost of goods sold, helping businesses assess production efficiency and pricing strategies. Calculating gross profit involves subtracting direct expenses from revenue, providing insights into cost control and financial performance.

By Brad Nakase, Attorney

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Table of Contents

1. What does gross profit mean?

2. How can you interpret gross profit?

3. What factors influence gross profit?

4. Calculation of Gross Profit

5. Example of the gross profit formula

6. What your company can gain from gross profit

7. How Does Gross Profit Margin Work?

8. How Can You Interpret the Gross Profit Margin?

9. What Constitutes a Good Gross Profit Margin?

10. Simple Steps for Determining Gross Profit Margin

11. Strategies for Increasing Your Gross Profit

12. Conclusion

What does gross profit mean?

In order to learn crucial things about profitability, business owners need to study a lot of numbers, one of which is gross profit. Here we will walk you through the basics of gross profit, including what it is, the way to calculate it, and why it’s important for better expense management and business growth.

After deducting the expenses associated with producing and delivering a company’s goods and services, the remaining amount is known as gross income or gross profit. This figure takes into account the variable costs of producing something, but it does not take into account the costs of selling or administrative duties. In the event that the business is a service-oriented enterprise that does not possess any inventory, the gross receipts and the gross profit are equal in value.

To talk about total sales, you can also use “gross profit.” Profit and loss statements normally include a gross income figure that is a standard formula for companies operating in the same sector.

How can you interpret gross profit?

Making business decisions is easier when you know your gross income. Gross income is a measure of how well a company is doing financially. To measure success, businesses can break down their reported gross income by product.

If you want to know how much business you need to make every year or month to turn a profit and what amount of production you need to reach to break even, you can use the individual components of gross income calculations. In the event that the cost of making a product is disproportionately high in comparison to the price that consumers are okay with paying, the business might not be able to generate sufficient revenue to cover the costs of expansion down the road.

What factors influence gross profit?

There are a lot of moving parts when it comes to gross profit as a measure of production efficiency for businesses. To start, there are some expenses that don’t change no matter how much you make. These include things like rent, insurance, employee salaries, and payroll taxes. Next, there are variable costs that might change based on the company’s production:

Sales changes
Raw material costs
Direct labor costs
Shipping expenses for products
Resources related to manufacturing
Inventory tracking system (e.g., LIFO, last in, first out)

Maximizing gross profits is directly proportional to minimizing variable expenses and keeping fixed costs low.

Calculation of Gross Profit

The equation for gross profit requires two variables: revenue and cost of goods sold (COGS). Cost of Goods Sold (COGS) includes the actual expenses incurred in making or purchasing a product, such as the cost of materials, transportation, packaging, storage, and direct labor. The cost of services sold can stand in for cost of goods sold when a business offers its customers services rather than physical goods. Sales for a specific time period add up to a total amount known as revenue or net sales.

The formula for gross profit is revenue minus the cost of goods sold (COGS), and the result is shown as a dollar amount:

Cost of Goods Sold – Revenue = Gross Profit

If you know the revenue and the cost of goods sold, you can calculate the gross profit. The sum of all sales is known as revenue. Anything you spend money on that is directly tied to making your goods or providing your services (like raw materials) is considered part of the cost of goods sold.

Operating expenses are not included. Operating costs could include things like rent, office supplies, insurance, interest, and taxes.

Example of the gross profit formula

Take a look at this example. You can tell which company spends its money better by comparing their profits.

Bakery 1

In the month of April, a bakery had sales of $15,000. The cost of goods sold was $10,000.

Revenue: $15,000

Cost of Goods Sold: $10,000

Deduct the cost of goods sold from the revenue. You subtract $10,000 from $15,000 for Bakery 1.

$15,000 – $10,000 = $5,000

There will be a $5,000 gross profit.

Bakery 2

The neighborhood is home to a second bakery. In April, Bakery 2 also made $15,000. However, their COGS is $7,000.

Revenue: $15,000

Cost of Goods Sold: $7,000

Once again, you deduct the cost of goods sold from the revenue. Take $15,000 and subtract $7,000 to get the gross profit for Bakery 2.

$15,000 – $7,000 = $8,000

In April, the gross profit amounted to $8,000.

A side-by-side look at the two bakeries:

Bakery 1: $5,000

Bakery 2: $8,000

The gross profit for Bakery 2 is three grand more. Comparing the two bakeries’ financial records reveals that the second one makes better use of its funds. This indicates that compared to Bakery 1, Bakery 2 uses less resources to generate the same amount of money.

Gross profit is an easy way to keep track of the costs that go into making money. Gross profit goes down when the cost of goods sold goes up. You now have less money to pay for your company’s expenses. Similarly, your gross profit will rise as the cost of goods sold falls. More capital is available for use in running your company.

What your company can gain from gross profit

What does “gross profit” mean for your company? For smaller businesses, it’s just one of many accessible, basic accounting tools. To see how well you generate income, look at this number. A higher gross profit is the result of higher revenue and lower production costs. But profitability and gross profit are two different things; don’t get them mixed up.

Based on your gross profit, you can make improvements to your business. Adjust your production costs if you find that they are approaching or exceeding your revenue. Identifying more cost-effective methods of production or service delivery could help you lower COGS. On the other hand, you could boost sales by stepping up your advertising game.

How Does Gross Profit Margin Work?

One way to look at a company’s financial health is to look at its gross profit margin, which is another name for the gross profit ratio. When a company’s gross profit margin is high, it means they’re good at keeping costs in check. When seeking investors or business funding, this may also be crucial since potential backers will want to see the company’s financials and proof that it can make money while keeping expenses low.

How Can You Interpret the Gross Profit Margin?

Since it shows how much money a company makes after deducting all of its operating expenses, the gross profit margin is a good indicator of its pricing strategy and financial health. The business risks losing money if its manufacturing expenses are higher than what consumers are ready to pay.

What Constitutes a Good Gross Profit Margin?

You can tell if a product is profitable for your company by looking at its gross profit margin. If a product’s gross profit ratio is high, it means that its profit after labor and other operational costs is high as well. Conversely, if your gross profit margin is small, it means that your selling price is barely covering your production costs. You may need to reevaluate your pricing strategy, tighten up your cost control measures, or reevaluate how you’re using your labor and raw materials.

What constitutes a satisfactory gross profit margin is subjective. Industry, business size, and conditions of the market all have a major impact on margins. The gross profit margin of an automobile dealership, for instance, will be substantially lower than that of a bank providing financial services. Because their COGS is significantly lower than that of product manufacturers, service fields that do not sell physical goods often enjoy larger gross profit margins.

Simple Steps for Determining Gross Profit Margin

One way to determine gross profit margin is to divide gross profit by net sales. Then, to get the percentage, multiply the result by 100.

Gross Profit / Net Sales x 100 = Gross Profit Margin

The gross profit margin percentage shows how much money was made before all the expenses like administrative costs, amortization, depreciation, and overhead were taken out.

Strategies for Increasing Your Gross Profit

Knowing the formulas for gross profit margin and gross profit will allow you to begin pinpointing opportunities for improvement or a change in direction for your company. If you want to boost your gross profit, here are a few things to think about:

To increase your gross profits, you must decrease your operating costs. To do this, you must examine all of your company expenses. An audit is a good place to start looking for ways to streamline company operations and save money, such as by outsourcing payroll or other repetitive tasks.

Take stock of your system for managing inventory. You risk losing money if products don’t move around on the shelf for a while or if you can’t tell if something is in stock. Be sure you have a method to monitor products as they go through the supply chain. Additional benefits include improved return tracking, less waste, and less shrinkage caused by customers or employees stealing. Additionally, you will be able to identify trends in sales, such as seasonal spikes and subsequent stock-outs.

Every so often, you should reevaluate your pricing strategy and consider holding sales or lowering prices. However, if you want to improve your bottom line, you could consider increasing the price of an existing product.

Investigate your competitors. Gross profit margin has many applications, one of which is comparing your production efficiency to that of similar businesses. If your company and a leading rival sell identical products at the same price but the competitor manufactures them for half the cost, the competitor will end up with more gross profits.

Reward loyal consumers. One sales strategy that can help boost profits is focusing on keeping current customers rather than finding new ones.

Conclusion

Cash flow management will always come up when you look at your business’ gross profit. You can learn a lot about the company’s financial health and efficiency in spending by familiarizing yourself with industry-standard profitability measures, including return on assets, profit margins, and return on investment.

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