What is gross profit?

Gross profit is a business' sales revenue minus its cost of goods sold (COGS). In other words, gross profit removes the direct costs of developing and producing the good or service from the total revenue received from its sale. Sales revenue, COGS, and gross profit are all line items that appear at the top of a business' income statement. In most instances, gross profit will be a larger figure than net profit.

A business' gross profit can also be displayed as a percentage of total sales revenue; the subsequent percentage is the gross profit margin. You can use the gross profit margin to measure your business' production efficiency. This is especially useful when you track your gross profit margin over time or compare the metric to others within the same industry.

What is cost of goods sold?

Because you remove COGS from sales revenue to calculate gross profit, it is important you know what to include in COGS. Your business' COGS includes all of the following:

• Raw materials costs
• Direct labor costs
• Shipping and handling costs
• Storage costs
• Overhead costs tied directly to production, such as the utilities required to keep machinery running

You should exclude expenses from COGS that are not directly related to production. Items to exclude from COGS include selling, general, and administrative (SG&A) expenses, depreciation, amortization, interest, and tax payments.

In certain cases, you may include depreciation in COGS in a roundabout way. For example, if your business assigns depreciation expense on a piece of machinery to overhead costs that are directly linked to production, it may be included in COGS.

Calculating gross profit

The formula to calculate gross profit is:

Sales revenue - cost of goods sold (cogs) = gross profit

For example, your business made $500,000 in toy sales this year. You spent $200,000 on materials to build the toys, $10,000 on shipping and handling costs, and $100,000 on wages for your production line employees. The total direct production expenses you should include in COGS is, therefore, $310,000. If you subtract $310,000 from $500,000 in toy sales, you arrive at $190,000 of gross profit.

How is gross profit related to gross profit margin?

Gross profit can also be used to calculate a common profitability measure, gross profit margin. The gross profit margin is simply your gross profit displayed as a percentage of total sales revenue. While gross profit is displayed as a dollar amount, gross profit margin is always displayed as a percentage.

Gross profit margin is used to analyze a business' success at managing their production processes and efficiency. Gross profit, displayed as a dollar amount, may fluctuate considerably year-over-year depending on your business' sales revenue fluctuations. To get a more accurate representation of the effects of your direct production costs on your business' goods or service, it's useful to look at the gross profit margin.

In the example above, your gross profit margin is $190,000 divided by $500,000, or 38%. You can compare this 38% metric to your previous years' gross profit margins. You could also use this metric to compare to other businesses within the same industry.

Because different industries have vastly different business offerings and gross profit margins, it is not useful to compare across different industries. However, you can use gross profit margin to compare your production efficiency with close competitors with similar business models.

What factors affect gross profit?

If you're analyzing your financial statements for a change in your gross profit margin, here are some items to consider. Some of the main factors that influence fluctuations in gross profit include changes in:

• Sales Volume
• Raw materials costs
• Shipping and handling costs
• Direct labor costs
• Utilities directly tied to production

Any substantial increase or decrease in these items will affect your business' gross profit. You may have no control over certain items, such as new legislation for minimum wage or a utility rate increase.

However, you can manage others through effective planning. For example, you can increase sales through a targeted marketing campaign. You could also perform time studies on your production staff or machinery usage to suggest areas for improvement or automation. Gross profit can tell you a lot about your business if you know where to look.