Gross profit is an excellent indicator of a product’s performance and can indicate when a company needs to cut costs to increase the pricing of its products. This article will explore what gross profit is, how to calculate it, its advantages and disadvantages. In addition the article will take you through what costs are considered when calculating the gross profit.
Key Takeaways
- Gross profit is calculated by subtracting the cost of goods from net income.
- Gross profit only concerns expenses related to the product or service, unlike net profit, which considers company-wise expenses.
- Gross margin is a derivative of gross profit, indicating what percent of revenue a company earns can be applied towards operating costs.
What is Gross Profit?
A company’s profit after reducing the costs related to making and selling its products, or the costs associated with providing its services, is called Gross Profit. It’s also called gross income or sales income in certain instances.
It’s a metric that’s reported on a company’s financial statements. Without a high gross profit, the longevity of a company is questionable.
What Affects the Gross Profit?
Net Sales
- Sales Returns- Most businesses allow products to be returned within specific time windows. This means the company has to provide the customer with a refund, but most of the time, the product can be added back to stock to be sold.
- Allowances- If a customer complains that a product was damaged during transportation or that the wrong product was shipped, the company may provide them with a partial refund. This isn’t as common as sales returns, but it still affects net sales.
- Discounts- Discounts are used mostly by companies that make revenue on an invoice basis, like a mobile data company. These companies may give customers a discount if they pay the bill earlier—for example, a 1% discount for customers who pay a 30-day invoice in 10 days.
Cost of Goods Sold
These can be either fixed, like labour costs, or varied, like the cost of utilities used in the production process.
- Production Costs- These are costs products incur during the production of goods.
- Inventory Acquisition Expense
- Labour Costs
- Raw Materials
How to Calculate the Gross Profit
The formula to calculate the gross profit of a business is quite simple.
Gross Profit = Net Sales – Cost of Goods Sold
Example 1
A company that produces and distributes glassware internationally has made US$ 4 Million in net sales, including returns and allowances. The costs of goods sold are US$ 2.3 Million. The costs of goods sold include the salaries of workers and the costs of raw materials used to produce the glassware and packaging. The gross profit of the company works out as follows.
Gross Profit = US$ 4 Million – US$ 2.3 Million
= US$ 1.7 Million
Example 2
A mobile data connection-providing company is supposed to make US$ 400 Million in net sales but ends up offering US$ 3 in discounts to customers who pay their bills within the first week of the invoice. The company incurred in providing mobile data to the customer base is US$ 120, including maintaining technology and labour costs like worker salaries. The gross profit works out as such.
Gross Profit = US$ 400 – US$ 3 -US$ 120
= US$ 277
How to Improve Gross Profit
Raise Prices
This is a risky but obvious solution, but raising the prices of products and services may be necessary under certain conditions. Let’s say the prices of raw materials are increased significantly. Raising the prices of the product might be the only option a company is left with.
Raising prices can reduce consumers’ purchasing power, keep deflation at bay and affect the poor disproportionately.
Recently in light of the pandemic and the related economic recession, there have been significant price hikes in all kinds of businesses and products. This has put significant pressure on people living paycheck to paycheck and damaged the economy.
Improve Efficiency
If a company has incurred more costs, but doesn’t want to put any pressure on the consumers by increasing prices, another option they have is cutting costs.
This can be done by several measures. Cutting unnecessary expenses, keeping a careful eye over the company’s expenses, investing in updated technology are some of the methods commonly used. In addition going paperless, utilising office space better or shopping for cheaper insurance may work.
Advantages of Using Gross Profit
Gross profit isolates the performance of a product or its selling. Operating and administrative costs aren’t considered, allowing the company to get a clearer idea about the product’s performance in the market. Teams can focus on strategies to increase the gross profit.
Gross profit is also considered a more controllable expense than other costs a company may incur. This is because the product’s price is within the company’s control, and the cost of goods can be manipulated easily.
Disadvantages of Using Gross Profit
Gross profit can indicate a problem that needs to be solved. However, companies have to start digging deeper into all revenue streams to see where the problem lies. This is because the gross profit cannot show where the problem lies.
Newer investors will have a hard time understanding how business operations are conducted based on gross profits, as it doesn’t point out the exact problems a business has.
Gross profit doesn’t consider administrative and operating costs. Companies like law firms or consulting agencies with no costs of goods sold will have a gross profit equal to net income. This can be misleading since the other hidden costs may be substantial.
Summary
Gross profit is a great metric that can show a company or a prospective investor the performance of a certain product or service in the market. Isolating the product-related costs from administrative and operating costs is a part of why.
However, omitting administrative and operating costs comes with its own set of problems, especially if you consider industries with little to no cost of goods production, so considering just the gross profit isn’t wise, especially if you’re an investor interested in the company.