Among the many metrics used in financial analysis and corporate performance management, gross profit remains one of the most important. Understanding the concept of gross profit and how it is calculated and applied during the analysis of financial performance is important for any business leader. Even those who are not decision-makers benefit from understanding this important financial concept.
In this FAQ we will discuss what gross profit is, how it is different from net income, why it is important in financial analysis, and how to calculate it.
What Is Gross Profit?
Gross profit is the amount of income that remains after accounting for production cost, sometimes referred to as cost of goods sold. The calculation is an indicator of how much profit remains after direct production or inventory costs are accounted for.
In financial statements that are prepared in accordance with US GAAP, gross profit is always shown on the income statement or statement of operations. It is an indicator of the business’s ability to generate a profit while simultaneously managing its production costs.
The term is sometimes used interchangeably with operating profit. Gross profit is typically used to judge how efficiently a business is able to manage costs related to producing the products it sells. The costs that are reduced from gross income typically include labor and raw materials. In some cases, selling expenses are also deducted from gross income to arrive at gross profit.
The Difference Between Gross Profit And Net Income
When assessing how well a business is performing it is important to analyze both the gross profit and net income. While gross profit is the amount of profit remaining after accounting for direct production and selling expenses, net income is the amount of profit remaining after accounting for all expenses.
Neither metric is considered inferior to the other, but rather they are complementary. The message they convey collectively is how efficiently a business is managing its production expenses and the impact of non-production-related expenses on the performance of the businesses.
Using the two values in tandem helps to identify where production inefficiencies exist or other non-production inefficiencies exist. For example, if gross profit is high, but net income is low then it alerts analysts to expense pressure that is unrelated to the production of the product that generates revenue.
Why Is Gross Profit Important?
There are a variety of reasons gross profit is analyzed and important to regularly review. Gross profit and the resulting gross profit margin are metrics that help identify how much profit can be used for the fixed expenses of the business. Its application helps FP&A analysts determine how much income is remaining that can be allocated to other areas of the business.
In simple terms, gross profit provides a relevant metric to balance the remaining fixed expenses of the business against. If gross profit is too low, then there is not sufficient income to cover fixed expenses of the business, and adjustments either need to be made to the cost of goods sold so that gross profit is increased or other fixed expenses need to be reduced.
Gross profit is used to gauge how efficiently a business is utilizing its labor, supplies, and raw materials. It can also provide insight into how efficient commission structures are and whether or not credit card agreements are accretive or damaging to gross profit.
One of the limitations of gross profit as a metric is that it can be misleading when compared to other time periods. For example, gross profit might go down period over period, but gross profit margin might have increased. Therefore it is important to consider both gross profit and gross profit margin together when analyzing income.
Gross Profit Margin
Gross profit margin is a metric that is helpful in analyzing gross profit over time. Where gross profit is expressed in terms of currency, gross profit margin is expressed in terms of percentages and represents the portion of gross profit compared to total revenue.
This is helpful for identifying trends as over time the expectation is that gross profit margin will increase, even if gross profit drops.
How To Calculate Gross Profit And Gross Profit Margin
The formula for calculating gross profit and gross profit margin has some prerequisites. Namely, an understanding of the cost of goods sold and what should be included in that, and total net revenue. Total net revenue is all revenue after any supplier incentives or rebates.
Gross Profit Calculation
Gross Profit = Total Net Revenue – Cost of Goods Sold
Gross Profit Margin Calculation
Gross Profit Margin =Gross Profit Total Net Revenue
It is important to note that the calculation of gross profit margin relies on the calculation of gross profit. This means that performing the two calculations in conjunction is easy.
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