What is Gross Profit?
Gross profit – also referred to as gross income or sales profit – is the total sales of a company minus the total cost of goods (COGS) sold. Gross profit margin is an important indicator of a company’s profitability.
How to Calculate Gross Profit
You can find gross profit listed on a company’s income statement. To calculate, take the difference between the cost of goods sold and total sales (aka revenue).
The Gross Profit Formula
The gross profit formula is expressed as follows:
Gross Profit Calculation Breakdown
Let’s break down the components of the gross profit formula:
1. Find the Total Sales
The total sales/revenue can be found by adding up all of the goods sold in a specific period of time. This may be done annually or quarterly.
2. Find the Cost of Goods Sold (COGS)
When calculating COGS, only variable costs (expenses that change depending on the quantity of product being produced) are included. For example, in a car factory, variable costs may include:
- Raw materials such as steel, plastic, and glass
- Electricity bills and utilities for the factory
- Assembly line labor wages
COGS doesn’t include fixed costs (expenses involved with the general upkeep of the business). In a car factory, these fixed costs might include:
- Rent, and
- Routine maintenance.
Gross Profit Example
Consider the example of a modified income statement from Car Manufacturer XYZ.
Car Manufacturer XYZ had a total revenue of $137,237,000 in 2019. That same year, the expenses involved with the production and distribution of its goods (COGS) was $123,265,000.
We can calculate Car Manufacturer XYZ’s gross profit by taking its overall revenue and subtracting cost of goods sold:
$137,237,000 − $123,265,00 = $13,972,000
In 2019, Car Manufacturer XYZ had a gross profit of $13,927,000.
Gross Profit vs. Net Profit
Gross profit should not be confused with net profit. Gross profit only considers production and distribution of its goods or services.
Net profit, however, is the revenue of a business that remains after all expenses are subtracted. It takes all fixed and variable expenses, interest, taxes, and preferred stock dividends into account.
Why Is Gross Profit Important?
Gross profit reveals how much revenue a business has after considering the costs of production.
On its own, gross profit doesn’t tell analysts or investors much about the performance as a business. Looking only at a company’s gross profit (as an indicator of profitability over time) can be deceptive and dangerous. Gross profit figures can rise even as a company’s gross profit margins decrease, which would indicate a drop in profitability.
Gross profit is important because it allows us to calculate other key financial metrics like gross profit margin.
Gross Profit vs. Gross Profit Margin
Gross profit allows you to easily find the gross profit margin, which is an indicator of company profitability. It shows the gross profit as a percentage of sales.
Why Is Gross Profit Margin Important?
A high gross profit margin suggests a business that is efficient at generating sales in excess of the costs of the goods sold, that is, one that’s more efficient at utilizing resources. Investors and analysts are able to use gross profit margin to track a business’s performance over time or compare a company to its industry competitors.
How to Calculate Gross Profit Margin
To calculate gross profit margin, divide gross profit by total revenue. The gross profit margin formula can be expressed as follows:
Gross Profit Margin % = Gross Profit/ Total Sales Revenue
Example of Using Gross Profit Margin
Using the Car Manufacturer XYZ’s income statement above, we can find the gross profit margin if we divide its gross profit by its total revenue. This would look like:
($13,927,000 / $137,237,000) x 100 = 10.15%
Let’s look at another calculation for competing Car Manufacturer ABC. The competitor had total revenue of $120,207,000 and gross profit of $10,515,000 in 2019. Using the above formula the gross profit margin is 8.75%:
$10,515,000/$120,207,000)x 100 =8.75%
If both companies are in the same industry, it’s easy to compare the gross profit margins to determine which company is performing more efficiently.
Because Car Manufacturer XYZ has a slightly higher gross profit margin, we can infer that it is more efficient at converting raw materials and labor into revenue. This suggests Car Manufacturer XYZ has more of its funds to direct towards savings, operations, and indirect expenses. Between the two companies, Car Manufacturer XYZ has a greater earning potential overall.
Limitations of Using Gross Profit Margin as a Metric
When viewed alone, gross profit margin can be misleading to assess a company’s profitability or future earnings potential. Gross profit margin only considers production costs and doesn’t include costs such as taxes, marketing, and rent. Because of this, gross profit margin is not always the most accurate measure of profitability and should be used in conjunction with other metrics.
For example, Car Manufacturer XYZ’s gross profit margin could be increasing, but if taxes, rent, and other costs rise even faster, the company may not be adapting to changing market conditions (and may be mismanaged).
Learn More about Financial Metrics for Companies
For investors, analysts, and managers, gross profit is only one of many financial metrics used to assess the financial health of a company. Learn more about financial metrics like return on equity (ROE), operating margin, and net profit margin.