What is Gross Profit?

Formula

It is calculated as below:

This formula only considers variable costs. Variable costs are the cost to the Company that varies with the output. It should be noted that the fixed costs are not considered when deducting the cost of goods sold from the revenue to calculate it.

Variable Costs include the following items:

  • Raw MaterialsLabourPackaging costsFreight costsSales commissionsSales CommissionsSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission.read more

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Example #1

A Company has a revenue of $ 50000, and its cost of goods sold was $ 30000. What is the gross income of the CompanyGross Income Of The CompanyThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity.read more?

Examples of Gross Profit

Solution:

GP =$50,000 – $30,000

The GP will be –

  • GP = $ 20000

Example #2

A Company in Auto manufacturing has the following items on its profit and loss statement. Calculate Gross Profit using the following data.

Selling and administrative expenses will not be added to the cost of goods since they are mostly fixed costs. Also, interest and financial expenses will not be added to the metric as they represent interest paid to the financers.

Gross Profit

  • $ 75000

GP Ratio will be –

Therefore,  Gross Profit Ratio = 62.5%

Colgate Example

Let us calculate Colgate’s GP

For FY 2015, GP = $16034 – $6,635 = $9,399.

Let us now calculate the Gross Profit Margin.

  • The cost of Operations includes the Depreciation related to manufacturing operations (Colgate 10K 2015, pg 63).Shipping and handling costs may be reported in the Cost of Sales or Selling General and Admin Expenses. Colgate reported these as a part of Selling General and Admin ExpensesSelling General And Admin ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc.read more.

  • If such expenses are included in the Cost of Sales, the Gross Ratio of Colgate would have decreased by 770 bps from 58.6% to 50.9% and decreased by 770bps and 750 bps in 2014 and 2013, respectively.source: – Colgate 10K 2015, pg 46

Methods to Increase the Gross Profit

Two methods can increase it:

#1 – Increase the price of products

The increasing price of products may decrease the number of products sold and thus, decrease the revenue as the customers will prefer buying a competitor product at a lower price. Therefore, the price increase should be done by considering the product’s inflation, competition, demand, and supply, quality of the product, and USP (unique selling point).

#2 – Decrease the cost of products

Variable costs can decrease by decreasing the inputs of the goods, i.e., raw material, or by the production of goods efficiently. The company can get discounts by purchasing raw materials in bulk from the supplier. Raw material costs can be decreased by purchasing material from a supplier that provides products at a cheaper rate. However, it may hamper the quality of the product. The Company can maintain or reduce costs by producing the goods efficiently.

Conclusion

Gross profit is the amount made by the Company after deducting the costs of goods soldDeducting The Costs Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more or the costs associated with the services the Company has provided. It is available on an income statement before deducting selling, general and administrative expenses (SG&A), non-operating revenues, non-operating expenses, other gains, and other losses.

Gross profit and its ratio are two key indicators that the investors look at in the Compan’s income statementCompan’s Income StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more. These provide a view of the financial performance of the Company. I.e., how well it manages the demand and supply of the goods and the variable costs associated with the production and sales of the goods.

This article has been a guide to Gross Profit and its definition. Here we discuss how to interpret Gross Profit and with examples and strategies to increase the same. You can learn more about accounting from the following articles –

  • Profit and Loss Statement TemplateCalculate Depreciation ExpenseWhat is Gross Profit Margin?Compare Profit and Income