How to Calculate Gross Profit

Gross Profit 

It is a required income statement entry that indicates total revenue minus cost of goods sold. It is the company’s profit before operating expenses, interest payment and taxes. It is also known as GROSS MARGIN.

The gross profit on a product is computed as:

Net Sales – Cost of Goods Sold (COGS)

This concept is well understood if you are able to clearly distinguish between variable and fixed costs.

VARIABLE COSTS:

• Materials used

• Direct labor

• Packaging

• Freight

• Plant supervisor salaries

• Utilities for a plant or a warehouse

• Depreciation expense on production equipment

• Machinery 

FIXED COSTS:

Fixed costs generally are more static in nature. They include:

• Office expenses such as supplies, utilities, a telephone for the office, etc.

• Salaries and wages of office staff, salespeople, officers and owners

• Payroll taxes and employee benefits

• Advertising, promotional and other sales expenses

• Insurance

• Auto expenses for salespeople

• Professional fees

• Rent 

Variable expenses are logged as cost of goods sold. Fixed expenses are counted as operating expenses (sometimes called selling and general administrative expenses).

While gross profit is a monetary entity, the margin is expressed as a percentage. It’s equally significant to track since it allows you to keep an eye on profitability trends.

Gross Profit Ratio = Gross Profit / Net Sales

The gross profit margin is computed as follows:

When the ratio is expressed in percentage form, it is known as gross profit margin or percentage.

Gross Profit / Net Sales *100 = Gross Profit Margin

It is equal to the net sales minus cost of goods sold and net sales are equal to total gross sales less return inwards and discount allowed.

Benefits of calculating gross profit:

1. This ratio determines how efficiently the management utilizes labor and raw materials

2. A company uses its gross income to fund activities such as research and development, marketing etc., which are vital for generating future sales.

3. A prolonged decline in this margin is a cleat-cut indication of sales drop-down and ultimately earnings.

4. Trends in this margin reflect basic pricing decisions and material costs of a company.

5. This profit margin is an accounting measure designed to estimate the financial health of a business or industry.

It may be noted that generating a profit margin alone cannot vouch for the financial health of a firm; rather the business must have sufficient cash flow in order to pay its bills and compensate employees. An entrepreneur might compare the return that would be available from a bank or another low-risk investment opportunity to that of his EXISTING profit-margin to gauge whether his startup is doing well.

→ Profitability Ratios