As a founder, understanding your company’s financials is crucial to make informed decisions about the business’s future. One of the most important financial metrics to track is gross profit, which measures the amount of revenue that remains after deducting the cost of goods sold (COGS).
In this blog, we’ll dive deeper into gross profit, how to calculate it, and why it matters for your business.
Gross profit is the key to measuring a company’s performance and understanding its financial health.– Jeff Bezos
What is Gross Profit?
Gross profit is a company’s total revenue minus its cost of goods sold (COGS). It is the amount of money that a company makes from selling its products or services, minus the costs associated with producing and selling those goods or services.
It is also sometimes referred to as gross margin.
Formula for Gross Profit?
|Gross Profit = Revenue – Cost of Goods Sold (COGS)|
➡️Revenue: Revenue is the total amount of money earned by a business from the sale of goods and services before any expenses are taken out. It is also known as the top line, gross income, or sales income.
➡️Cost of Goods Sold(COGS): The cost of goods sold is the total cost incurred by a business to produce and sell the goods and services it offers. It includes expenses such as materials, labour, and overhead costs associated with making the product or providing the service. It does not include any additional costs such as marketing and administrative expenses
COGS includes the cost of materials, labour, and other direct expenses associated with producing a product or providing a service.
Example of Gross Profit: How to Calculate?
Let us take the example of company ABC and let’s have a look at their net sales and cost of goods.
Company ABC’s Income Statement:
Net Sales: Rs 1,00,000
Cost of Goods Sold: Rs 60,000
|Particulars||Amount (in Rs)|
|⇒ Gross Profit||40,000|
|Gross Profit Margin||Gross Profit ÷ Net Sales|
|40,000 ÷ 1,00,000|
Methods to calculate gross profit
- Subtraction Method: This is the most common method of calculating gross profit. The formula for calculating gross profit using the subtraction method is:
Gross Profit = Revenue – Cost of Goods Sold
Revenue is the total income earned by a company from selling its products or services, while the cost of goods sold (COGS) is the direct cost incurred to produce or purchase the products or services sold. Gross profit is the difference between revenue and COGS.
- Division Method: This method calculates gross profit as a percentage of revenue. The formula for calculating gross profit using the division method is:
Gross Profit Margin = (Gross Profit / Revenue) x 100
The gross profit margin is a percentage that represents the portion of revenue that is left after deducting COGS. It is a useful metric for comparing the profitability of companies in the same industry. A higher gross profit margin indicates that a company is more efficient at generating profit from its sales.
What are the Advantages of Gross Profit?
Gross Profit is helpful in determining the financial health of a company. Let’s have a look at the advantages.
- Improved Cash Flow: It increases cash flow for a business, as it reduces the cost of goods sold, which is an expense that needs to be paid out of the business’s cash reserves.
- Increased Profitability: It is also a measure of profitability, as it measures how much income the business generates after subtracting the cost of goods sold.
- Increased Ability to Invest: A higher gross profit means that the business has more money to invest in activities that will help it stay competitive and grow. This could include investing in new technology or expanding the business’s operations.
- Increased Equity Value: A higher profit can also increase the value of a business’s equity since it is a measure of the business’s profitability. This could make the business more attractive to potential investors and could lead to a higher market value for the company.
What are the Limitations of Gross Profit?
There are certain limitations associated with Gross Profit. Let’s have a look at them.
- It does not take into account all of the expenses associated with running a business, such as overhead costs, taxes, and interest payments.
- It does not provide an accurate picture of the profitability of a business since it does not factor in fixed costs and non-sales-related expenses.
- It does not take into account the value of inventory or assets such as buildings, equipment, and vehicles.
- It does not provide an indication of the company’s future performance, as it does not include information about cash flow or potential new investments.
- It cannot be used to compare the performance of different companies since it does not take into account factors such as the size of the company, its market share, or its competitive advantages.
Gross Profit Vs Gross Profit Margin
Although the terms might sound similar, gross profit and gross margin have a number of differences. Let’s have a closer look.
|Gross Profit||Gross Profit Margin|
|It is the difference between a company’s total sales revenue and its cost of goods sold (COGS).||It is the ratio of gross profit to total sales revenue, expressed as a percentage.|
|Gross Profit = Revenue – Cost of Goods Sold (COGS)||Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue|
Gross Profit vs Net Income
Let us understand the difference between gross profit and net income.
|Gross Profit||Net Income|
|It is the difference between a company’s revenue and the cost of goods sold. It is equal to the company’s total sales revenue minus the cost of goods sold (COGS).||It is the difference between a company’s total revenue and total expenses. It is equal to the company’s total revenues minus total expenses, including COGS, operating expenses, taxes, and interest.|
|This number is used to determine how much money a company makes after it has paid for production-related costs.
It is a key metric used in financial analysis and helps investors and analysts understand the financial performance of a business.
|It’s a key indicator of a company’s financial health.
It is often used to compare a company’s performance over time or to its competitors.
|It can be used to compare the performance of different companies, sectors, or time periods. Additionally, it is a good indicator of a company’s ability to manage its costs and generate profits.||It is also used to determine dividend payments to shareholders and to calculate the company’s return on investment.|
What does Gross Profit tell about a company?
➡️Gross profit can tell you the amount of money a company has made after accounting for the cost of goods sold.
➡️It also helps determine how efficient a company is in managing its expenses and how profitable it is over a period of time.
➡️It can tell you about the financial health of a company. It is the amount of money a company makes after subtracting the cost of goods sold from its total revenue. This indicates how much of the total revenue is actually profit and how much is being spent on expenses.
|A higher gross profit margin indicates that a company is more profitable, meaning it has more money to reinvest in its operations. It can also indicate how efficient a company is when it comes to pricing its products or services.|
Gross Profit can help determine the right pricing of the product, and analyse the costs of labour, and operations.
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Frequently Asked Questions
What does gross profit measure?
Gross profit measures the profit a company makes after subtracting the cost of goods sold from the revenue generated from the sale of goods or services. It is an important metric used to measure a company's overall performance and profitability.
What is the difference between gross profit and net profit?
Gross profit is the amount of revenue that remains after subtracting the cost of goods sold. It is calculated by subtracting the cost of goods sold from the revenue generated from the sale of goods. Net profit is the amount of revenue remaining after deducting all operating expenses, including cost of goods sold, operating expenses, taxes, and interest payments. It is calculated by subtracting all operating expenses from the gross profit.
How Do You Calculate Gross Profit?
Gross profit is calculated by subtracting a company's total cost of goods sold (COGS) from its total revenue. The resulting figure is the gross profit, which is used to measure the profitability of a business. Gross Profit = Total Revenue - Cost of Goods Sold (COGS)
What is a good gross profit margin?
A good gross profit margin varies depending on the industry, but generally, a gross profit margin of 30% or higher is considered good. However, it's important to note that a high gross profit margin doesn't necessarily mean a company is profitable, as other expenses such as operating expenses, taxes, and interest also need to be considered.
Can gross profit be negative?
Yes, gross profit can be negative if the cost of goods sold is higher than the revenue generated. This means that the company is losing money on each unit sold.