Gross profit, also known as gross income, appears on income statements that helps companies determine how much they actually earned after revenue.
What Is Gross Profit?
Gross profit is an important measure of a company’s operating efficiency. It’s a metric of how much of a company’s revenue is consumed by the production of goods or services. It generally does not include fixed costs that aren’t directly tied to the production of goods or services.
Gross Profit Explained
Gross profit is the profit a company makes after deducting costs associated with making its products or services. While gross profit does not provide a complete view of a company’s profitability because it excludes other corporate expenses, it helps companies assess whether they can make a product or deliver a service efficiently. It can also be helpful in the financial analysis used to set pricing. Gross profit is sometimes referred to by other names, such as gross income and sales profit.
How to Calculate Gross Profit
Gross profit is calculated by deducting the cost of goods sold (COGS) or cost of sales (COS) from net sales revenue.
Net sales revenue is defined as the amount of money generated from selling goods and/or services to customers, after subtracting discounts, allowances and returns.
COGS is calculated by totaling the costs associated with manufacturing products or acquiring goods for resale. These are primarily variable costs that rise or fall relative to production, as the costs of production are often recorded before revenue from the sale of goods is recognized.
U.S. Generally Accepted Accounting Principles (GAAP) requires the use of absorption costing when determining COGS for external financial reporting, though it’s not recommended for internal purposes. This method captures both variable and fixed costs, such as overhead associated with operating a manufacturing facility. Absorption costing is required when valuing inventory under U.S. GAAP.
For retailers, there are several GAAP-approved methods for determining COGS. For the most common method, the three components are inventory value, freight-in costs and warehouse labor. Store labor costs, including commissions, are generally not included. Credit processing charges are not included in the standard method either.
Gross Profit Formula
Gross Profit = Net Sales Revenue – COGS
Gross Profit vs Gross Profit Margin
A company determines its gross profit margin by dividing gross profit by net sales revenue and expressing the result as a percentage. While gross profit measures how much cash is left over from product sales after accounting for cost of goods sold, gross profit margin measures how profitable those products are.
However, a gross profit margin of 35% doesn’t necessarily mean that 35% of revenue becomes profit. Operating and non-operating costs must also be subtracted. This will give you net profit and net profit margin. A 35% net profit margin would mean 35% of revenue is retained as profit.
For example, a company’s rising sales might result in an increase in gross profit expressed in cash terms. But if the cost of labor or raw materials increases at a faster rate than the increase in sales, its gross profit margin will decline.
Gross Profit vs Net Profit Margin
Net profit margin differs from gross profit and gross profit margin in that it provides a more complete measure of a company’s overall profitability, since it takes into account all the company’s expenses — not just COGS. Because of this, net profit margin is widely used as a profitability metric.
A company determines its net profit (net income) by taking gross profit and subtracting its operating and non-operating. Net profit margin is then calculated by dividing the net profit by sales revenue.
Net profit margin can decrease even if gross profit and gross profit margin are increasing — for example if a company’s operating expenses are rising faster than sales.
Where Is Gross Profit on an Income Statement?
Gross profit is found near the top of a company’s income statement, just after the line items for revenue and COGS or Cost of Sales (COS), since gross profit is the subtraction of COGS or COS from net revenue.
Importance of Gross Profit
Businesses can use gross profit as a metric to assess the profitability of individual business segments or products, but gross profit doesn't indicate whether the business as a whole is profitable. A company can have a high gross margin but still lose money. Gross profit and gross margin indicate how efficiently a company uses its assets to generate revenue.
Manufacturers, for example, can measure gross profit for individual products by dividing product revenue by the costs associated with the product. Annual or quarterly fluctuations in a company’s gross profit may indicate changes in a company’s sales productivity. Companies can also use gross profit margin as a measure of executive performance, because it indicates how efficiently the company is generating revenue and profit from its products.
Gross Profit Example
If a manufacturer has net sales of $128,000 and has a total cost of goods sold of $77,000, then its gross profit is $51,000 ($128,000 minus $77,000). The gross profit margin is 40% (gross profit of $51,000 divided by net sales of $128,000).
In the example below, from Apple’s Form 10-K for the fiscal year ended September 28, 2019, Apple reported revenue of just over $260 billion. Note that Apple uses the term “net sales” to refer to revenue, and “gross margin” to refer to gross profit (in dollars).
Subtracting the cost of sales (COGS and cost of services) of approximately $162 billion leaves a gross profit of about $98.4 billion. To calculate Apple’s gross profit margin for 2019, divide this figure by revenue (net sales), resulting in a gross profit margin of 37.8%.
We can determine the separate gross profit margins for Apple’s products and services. Apple’s gross profit margin for its products is 32.2% (product sales minus cost of product sales, divided by product sales). Services has a net profit margin of 63.7% (services sales minus cost of services sales, divided by services sales).
Small businesses, and even startups, can also use gross profit and gross profit margin as a comparative financial metric by comparing them against the financial statements of publicly traded companies in their industry.
Analyzing gross profit can also help companies set or adjust prices for products and services in order to achieve their financial goals. Understanding the costs associated with manufacturing and selling a product also helps companies plan for potential fluctuations in the cost of raw materials and labor.