Income Statement of a company is one of the richest sources of information concerning its financial health and standing. There are numerous measures in an Income Statement that facilitate one’s understanding of the factors as mentioned earlier. One of these measures is the gross profit of an organisationThe Gross Profit (GP) of a business is the accounting result obtained after deducting the cost of goods sold and sales returns/allowances from total sales revenue. GP is located on the income statement (sometimes referred to as the statement of profit and loss) produced by a company and used to determine a company’s gross margin.
What is Gross Profit?
Gross profit is the measure of a company’s profits directly stemming from its sales after accounting for the Cost of Goods Sold or COGS.
In other words, it is the excess of revenues in an accounting period over the costs directly related to providing services or production of goods. Such costs can be broadly bifurcated into manufacturing expenses and labour costs.
It is a key measure for both concerned companies and outsiders like shareholders, investors, etc.
Gross profit provides an understanding of a company’s management soundness. It also helps to gauge the amount it can retain from sales to mitigate other operational expenses, liabilities, distribute dividends, and keep in reserves.
Furthermore only manufacturing expenses and labour costs are excluded from total revenue generated in an accounting period. It, thus, portrays a company’s managerial efficiency in utilising such resources to produce goods and render services.
How to Calculate Gross Profit?
1. Calculation of COGS
As mentioned before, the cost of goods sold includes the expenses that are directly related to production. In other words, COGS includes the variable costs. This category of cost incorporates –
- Raw materials
- Packaging
- Direct labour
- Freight or shipping charges
There might be other expenses as well that go into producing goods and providing services.
Generally, fixed costs are not included in the calculation of gross profit. These are costs that do not fluctuate with changes in production scale, such as the salary of employees, office rent, etc. However, under absorption costing a portion of such fixed costs are incorporated on a per-unit basis. According to GAAP, absorption costing is necessary for external reporting of a company’s finances.
Nevertheless, as per accounting practices, COGS = [Inventory (opening balance) + Purchases] – Inventory (closing balance)
Example: Company KLM purchased Rs.50000 worth of inventory in the fiscal year 2019 – 20. The opening inventory value on 1st April 2020 was Rs.2 lakh. The closing inventory value on 31st March 2020 was Rs.2.25 lakh. Therefore, COGS = Rs. [(200000 + 50000) – 225000] = Rs.25000.
2. Calculation of net sales
Net sales involve the total amount of gross sales – both in cash and credit – in a particular year minus the sales returns, allowances, and discounts.
Thence, Net Sales = Gross Sales – (Returns + Discounts + Allowances)
Example: Company KLM recorded sales worth Rs.1.5 lakh in the fiscal year 2019 – 20. Out of that, goods worth Rs.25000 were returned due to spoilage. It also allowed a discount of Rs.5000 against a sale of Rs.50000. Ergo, its net sales = Rs.150000 – (25000 + 5000) = Rs.120000.
In case there are no adjustments against the gross sales amount, it is considered as net sales.
3. Calculation of gross profit
Finally, after the calculation of both COGS and net sales, GP can be computed using the gross profit formula, i.e.
Gross Profit = Net sales – Cost of Goods Sold
Why Is Gross Profit an Important Measure?
As mentioned previously, the gross profit of a company is a critical measure of its financial standing and management efficiency. Therefore, the two most crucial inferences that can be drawn from the gross profit are –
- The value of resources a company is utilising behind the production.
- The scale of revenue it can generate against such resources.
Gross Profit vs Gross Margin
Gross margin, also known as gross profit ratio, is the ratio between a company’s gross profit and total revenue. As opposed to gross profit, gross margin betrays the profitability of a company.
Therefore, it is a more reliable metric for gauging a company’s financial health and also its ability to manage cost in relation to total revenue effectively. Furthermore, it is also a critical measure of comparison between companies with different market capitalisations.
Gross margin is calculated using the following formula –
Gross margin = Gross profit / Total revenue
The difference between gross profit and gross margin can be further understood with the help of examples.
Gross Profit example: In FY 19 – 20, Company A recorded sales worth Rs.25 lakh and incurred production expenses of Rs.15 lakh. Therefore, its Gross Profit = Rs. (2500000 – 1500000) = Rs.10 lakh.
Gross margin example: Let’s consider the above instance of Company A. According to the gross profit calculator, its GP came about to be Rs.10 lakh. Ergo, its Gross Margin = (1000000 / 2500000) = 0.4 or 40%
FAQs
What Does Gross Profit Measure?
Gross profit equals a company’s revenues minus its cost of goods sold (COGS). It’s typically used to evaluate how efficiently a company manages labor and supplies in production. Gross profit will consider variable costs which fluctuate compared to production output. These costs may include labor, shipping, and materials.
What Is the Difference Between Gross Profit and Net Profit?
Gross profit is the income remaining after production costs have been subtracted from revenue. It helps investors determine how much profit a company earns from the production and sale of its products. Net profit or net income is the profit that remains after all expenses and costs have been removed from revenue. It helps demonstrate a company’s overall profitability and reflects the effectiveness of a company’s management.
