Understanding Gross Profit
Gross profit is used in assessing the efficiency of a company at utilizing its labor and supplies in producing goods or services. The metric mostly consider variable costs, which is costs that vary with the level of output like:
- Direct labor
- Commissions for sales staff
- Credit card fees on customer purchases
How Does Gross Profit Work?
The gross profit is the preliminary measure of profitability before operating income and net income.
Is Gross Profit that Important?
Yes. This is because gross profit, reflects the core profitability of a company before overhead costs, and it illustrates the financial success of a product or service.
Gross profit is very vital in calculating gross profit margin which can be calculated by simply dividing gross profit by total revenue (gross profit / total revenue). Now calculating gross profit margin enables you to compare similar companies to each other and to the industry, on the whole, to help in determining relative profitability.
Companies that have higher gross profit margins are known to have a competitive advantage over competitors. This is because they can either charge a higher price for goods/services (as reflected in higher revenues) or because they pay less for direct costs (much like that reflected in lower costs of goods sold).
Gross Profit Formula
The gross profit formula goes thus:
Gross profit = Sales Revenue – Cost of Goods Sold.
Gross Profit vs Gross Profit Margin
Gross profit can also be used to calculate the gross profit margin. This is a metric that is useful for comparing a company’s production efficiency over time. If a business only compares gross profits from year to year or quarter to quarter it may be misleading because gross profits can rise while gross margins fall, a disturbing trend that may spell doom for a company.
Now note that although gross margin and gross profit margin are similar and used interchangeably they are not the same. Gross Profit is expressed as a currency value, while the gross profit margin is expressed as a percentage.
Limitations of Gross Profit Margin
Some standardized income statements are known to be prepared by financial data services, may give slightly different gross profits. These statements conveniently display gross profits as a separate line item, even though they are only available for public companies.
Gross and Net Profit on the Income Statement
Businesses are to record both gross and net profit on their small business income statement. Your income statement should display your revenue, followed by your cost of goods sold, as well as your gross profit. The next section displays your operating, interest, as well as tax expenses. Now the bottom line of the income statement is your net profit.
Knowing the Difference between Gross and Net Profit
Owners of small businesses need to know the difference between businesses’ gross and net profits. Here’s why:
- Investors and lenders would want to know about the financial health of your business, and showing them your gross profits won’t suffice. Thus you must understand your company’s net profits when seeking outside lenders. Thus, investors and lenders can determine how much money you have after paying all your expenses.
- It is also important in creating your income statement. You must know how to calculate both gross and net profit, in order not to confuse the two to avoid mistakes.
- It is also important to know the difference between gross profit and net profit if you want to make educated business decisions. This is because knowing the difference can help you come up with ways to reduce your cost of goods sold or increase product prices.