What Is Gross Profit?
A company’s gross profit refers to the total revenue a business earns over a given accounting period minus the direct costs associated with earning that revenue.
Revenue refers to the income received from regular business operations. In most cases, revenue is the money generated by sales of goods and/or services. It is often called the “top line” figure because it is the first entry on a company’s income statement.
Cost of Revenue includes the operational cost of products and services sold, as well as the expenses directly related to making the sale of those products and services. In a business that sells physical goods, the cost of revenue generally refers to Cost of Goods Sold (COGS). Overhead costs not directly related to sales, such as payroll taxes, building rental, and administrative expenses, are not generally included in the cost of revenue.
Gross profit can be calculated using the following formula:
Gross Profit = Revenue – Cost of Revenue
If a business has an increase in revenue over an accounting period or production costs decrease, there will be a higher gross profit for that period than the period before. However, if production costs increase or revenues decrease, the gross profit will be lower.
For instance, suppose a company experiences an increased demand for its products over the holiday season. This will lead to an increase in revenue. However, it may also require hiring temporary workers, paying overtime wages to existing employees, and/or increasing efficiency to meet the demand. Gross profit helps determine the best balance to maximize profitability.
Why Gross Profit Is Important?
Gross profits are important because the analysis helps companies optimize the performance of their company. Gross profit figures, evaluated over time, help a company determine how well it is managing its costs and marketing its products. A decline in gross profit may indicate a serious problem that needs to be addressed. An increase may show that recent changes are working and should be continued or enhanced.
Suppose your company brought in $100,000 in revenue last month. Your cost of revenue was $60,000. Therefore, your gross profit is: $100,000 – $60,000 = $40,000
Now we compare against the previous month, where revenue was $90,000 and cost of revenue was $40,000. The gross profit for that quarter was: $90,000 – $40,000 = $50,000
There seems to be a problem here. Even though revenue increased during the most recent accounting period, your company’s gross profit went down substantially. If this was unexpected, it may indicate a need to cut costs or increase productivity.
Limitations of Gross Profit
Gross profit is best used as a metric for measuring company progress over time. Taken by itself, it reveals little other than the scale of operations. It does not facilitate a comparison between companies or analysis of overall company efficiency. Gross profit is just one of several financial figures that need to be taken into account.
Gross Profit vs. Net Profit
To determine whether the company made or lost money, the financial advisor needs to consider overhead expenses and other costs not directly associated with production.
Gross profit recognizes only the cost of goods sold. These are variable costs directly related to the production and sales of products and services. Net profit refers to the profit remaining after all expenses are taken into account.
Net profit includes operating expenses, sometimes called overhead costs, as well as interest, taxes, etc. These are fixed costs that are not directly related to production. Some of these expenses may include administrative salaries, rent, insurance, utilities, and taxes.
For instance, in the example above, suppose that last month your company’s overhead expenses included $5,000 for building rental, $10,000 for management salaries, and $5,000 for utilities. That makes $20,000 in additional expenses. Subtracting these expenses from gross profit, your net profit is: $40,000 – $20,000 = $20,000
In the previous month, let’s say you had the same expenses plus a $5,000 legal bill. The net profit for that month was: $50,000 – $20,000 – $5,000 = $25,000
Other Metrics Calculated from Gross Profit
Gross income can be calculated from gross profit by adding in other sources of revenue not related to products and services. These may include such things as donations, grants, rental income, gains or losses from asset sales, royalties, and investment gains or losses.
Gross Income = Gross Profit – Operating & Miscellaneous Expenses
Gross profit margin or also referred to as Margin is a percentage or ratio that may be calculated for individual products or for the company as a whole. The formula for calculating gross profit margin is:
Gross Profit Margin = Gross Profit ÷ Sales
Net income, often referred to as the “bottom line,” takes into account all revenue and all expenses from the accounting period.
Net Income = Gross Profit + Other Income – Operating & Miscellaneous Expenses
Once net income has been calculated, it is possible to calculate EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This is a measure of profitability often used to help investors analyze a company’s financial performance.
EBITDA = Net Income + Interest + Taxes + Depreciation expenses + Amortization expenses
Gross profit is an important part of a company’s income statement. It helps measure the company’s ability to balance revenue generation with operational efficiency over time. It facilitates other important calculations that measure the overall health of a business.
If you have questions about this or other financial topics, we invite you to visit preferredcfo.com or talk with one of our CFOs.
About the Author
David Guyaux brings over 25 years of experience as CFO, VP of Finance, and Controller roles within both public and private enterprises. He has organized finances for companies to turn around operations and meet compliance and governmental requirements, as well as to prepare for mergers and acquisitions.
You may also be interested in...
Cost analysis and price analysis are two important procedures that are used by businesses to calculate the true cost of a product or service and determine the best sales price. By understanding and correctly utilizing these processes, businesses can make informed...
Before starting a new business—and periodically thereafter—it is important for company executives to carry out a market analysis, also called a market evaluation. Most entrepreneurs conducted a market analysis (to the best of their abilities) when they were developing...
A fractional CFO is an experienced CFO who provides services for organizations in a part-time, retainer, or contract arrangement. This offers a company the experience and expertise of a high-end CFO without the in-house cost—salary, benefits, and bonuses—of a...
Generally Accepted Accounting Priciples (GAAP) Financial reporting is an important part of business that communicates the financial performance and results of a company. It records and presents information about the company’s financial position, revenues, expenses,...
The end of the fiscal year can be highly stressful for financial officers and corporate executives. The year-end closing procedure is time-consuming and sometimes brings unpleasant surprises. Particularly in times of economic downturn and short staffing, year-end...
The wise business owner will “know what they don’t know,” and will seek the appropriate experts such as financial advisors to fill those gaps.
If Your Company Doesn't Have a Financial Forecast, You're Wasting Time and Money Every company has goals. Where do you want your organization to be 5 years from now? 10 years? Most even have a general idea of the benchmarks you need to hit to get there—"By increasing...
Whether implementing a new software system, adding office space, acquiring another company, or any other substantial investment, companies want to know how long it will take to recoup the money they spend on major purchases. The way to determine this is by calculating...
Finding funding for your business is a process that takes a lot of time and effort, especially during the startup phase. Many entrepreneurs fail in their first attempts at fundraising because they are poorly prepared. Others get themselves into trouble by choosing the...
In these days of economic challenges and changes, many companies struggle with uncertainty about the future, seeking tools and resources to best position their businesses for financial success. Often it can be beneficial to bring in a financial advisor who has...
What is a Cap Table? Capitalization tables, commonly called “cap tables,” are highly useful spreadsheets maintained by companies that have multiple owners or investors. Cap tables are especially important for private companies at startup and in the early stages of the...
Many companies experience times when they find their accounting departments short on staff or short on expertise. Sometimes emergencies and financial needs arise that are beyond the capability of their financial personnel to address. This is particularly true in times...