Gross Profit: Meaning and Formula
Explanation
Gross profit is what is left from the funds received from the sale of goods or provision of services after accounting for the COGS. It is an indicator of the profitability level of a company. It depends on a number of factors such as the cost of materials, the number of sold goods, and so on.
At the same time, you cannot draw conclusions about the success of a business based on only one indicator. In addition to gross profits, it is recommended to analyze different data to assess the organization’s performance. For example, based on gross profit, business owners or accountants can make other calculations, such as gross margin and operating profit.
Calculation
Gross profit is computed by companies on regular basis. The larger the business, the more often it is calculated. See below what the calculation formula looks like.
However, do not rush to make important decisions based on the received data. If your company sells several types of products, then the total gross profit will not tell you which one brings the most income. Therefore, do the calculations separately for each type of activity.
For example, Jessy & Co makes purses. Their gross profit is the proceeds from the sale of purses. Jessy & Co invested $50,000 in the making of purses and earned $100,000 from sales. The gross profit is $50,000. From this amount, the company will pay taxes, interest on loans, wages, rent, and utilities. As a result, $8,000 remains from the profit.
The gross profit is used in order to understand what intermediate money the company already has, what it can be spent on, and where it is better to wait and earn extra money. In general, gross profit is an indicator that helps to effectively spend the money earned. Regular monitoring of the dynamics of gross profit along with other indicators allows you to identify changes in work, find weaknesses, and adjust business strategy to maintain business profitability.
Profit types
Profit is the difference between a company’s revenue and expenses. The classification of this indicator depends on the data used for the calculation. Therefore, there are several types of profits one should know about. Understanding the difference between all of these indicators is extremely important for the correct allocation of company resources and assessment of its performance.
For example, interest expense, taxes, and other deductions are not accounted for in gross profit. Consequently, part of this amount still needs to be directed to these needs. Net profit is what will remain with you from the gross profit after these payments are made. This is how much the investors and owners can “take home”.
Example
Revenue is all the funds, excluding sales tax, that a company receives when it sells goods or services. Production costs, salaries, and any other spendings are not deducted from revenue. The Jessy & Co company sold 100 backpacks in a year. Each backpack costs $300. The revenue of Jessy & Co is $30,000.
The costs are what the company spent on production. This includes salaries of employees who sew backpacks, materials that go into making them, and other direct expenses. Jessy & Co spent:
- fabrics and accessories for backpacks – $3,000
- workshop rent – $2,000
- salary of employees – $7,000
- other direct expenses – $1,000.
It turns out that the cost of the backpacks is $13,000. Now, we can calculate the gross profit: $30,000 – $13,000 = $17,000. The company earned $17,000 from the sale of backpacks. The company will also deduct taxes from this amount, spend part of this profit on other expenses and receive a net profit.