Gross profit
Gross profit is the amount of profit remaining after a business deducts the cost of goods sold (COGS) from its revenue during a specified accounting period. It measures the profitability of a company's products or services before operating expenses, interest, taxes, and other non-operating items are taken into account.
Gross profit is commonly used to evaluate the efficiency of a company's production, purchasing, and pricing activities.
Calculation
Gross profit is generally calculated as:
For a company that sells physical products, cost of goods sold may include costs directly associated with producing or acquiring those products.
Gross profit margin
The gross profit margin expresses gross profit as a percentage of revenue.
A higher gross profit margin generally indicates that a greater proportion of revenue remains after covering the direct costs of goods or services sold.
Revenue
Revenue represents income generated from an entity's ordinary business activities.
Revenue may arise from:
- sales of goods;
- provision of services;
- subscriptions;
- licensing;
- other operating activities.
Gross profit is calculated after deducting the costs directly associated with generating that revenue.
Cost of goods sold
Cost of goods sold (COGS) represents costs directly associated with goods or services sold during a reporting period.
Depending on the business, COGS may include:
- raw materials;
- direct labor;
- manufacturing costs;
- inventory purchases;
- freight and other directly attributable costs.
The precise composition of COGS depends on the nature of the business and the applicable accounting framework.
Gross profit and operating income
Operating income is calculated after deducting operating expenses from gross profit.
A simplified relationship is:
Operating expenses may include:
- administrative expenses;
- selling expenses;
- marketing expenses;
- research and development;
- rent;
- depreciation;
- other operating costs.
Therefore, gross profit is generally higher than operating income when a company has operating expenses beyond COGS.
Gross profit and net income
Net income is calculated after accounting for a broader range of expenses and income.
A simplified relationship is:
Gross profit therefore does not measure the final profitability of a business.
Gross profit and cash flow
Gross profit is an accounting measure and should not be confused with cash flow.
A company can report a high gross profit while experiencing weak cash flow because of factors such as:
- increases in accounts receivable;
- inventory investment;
- operating expenses;
- capital expenditure;
- debt repayments.
Gross profit and pricing
Gross profit can be affected by changes in selling prices and direct costs.
If revenue increases while COGS remains unchanged, gross profit generally increases.
Conversely, an increase in direct production or acquisition costs can reduce gross profit if selling prices do not increase correspondingly.
Gross profit and cost management
Businesses may seek to improve gross profit by:
- increasing selling prices;
- reducing direct production costs;
- improving procurement;
- increasing production efficiency;
- reducing material waste;
- improving product mix.
These measures can affect the gross profit margin even when total revenue remains unchanged.
Example
Suppose a company generates revenue of US$10 million and incurs US$6 million in COGS.
Gross profit is:
The company therefore has gross profit of US$4 million.
Its gross profit margin is:
The gross profit margin is therefore 40%.
Importance
Gross profit is a fundamental measure of operating performance because it shows how much revenue remains after accounting for the direct costs associated with goods or services sold. It is widely used in Financial analysis to evaluate pricing, production efficiency, cost management, and changes in business profitability.