GROSS PROFIT: WHAT IT CONSISTS OF, HOW IS IT CALCULATED, EXAMPLES - DUDAS - 2025

The gross profit, also known as utility sales or gross income is the profit obtained by a company after deducting the costs associated with the manufacture and sale of its products, or the costs associated with the provision of their services.

This is a mandatory entry in the income statement, reflecting total revenue less cost of merchandise sold. It is the profit of a company before operating expenses, interest payments and taxes.

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Evaluates the efficiency of a company in the use of its direct labor and supplies. The indicator only considers variable costs, that is, costs that fluctuate according to the level of production.

As generally defined, gross profit does not include fixed costs, or costs that must be paid regardless of the level of production. It is important because it reflects the core profitability of a business before overhead, and illustrates the financial success of a product or service.

What does it consist of?

To understand gross profit it is important to know the difference between variable and fixed costs.

Variable costs are those that change according to the amount of product that is manufactured. They are incurred as a direct result of product manufacturing. Variable costs include:

- Used materials.

- Direct labor.

- Packing.

- Salaries of the plant supervisor.

- Utilities for the plant or warehouse.

- Depreciation expenses of production equipment.

Fixed costs are more static in nature. They do not vary with the amount of product that is manufactured. Among these costs are:

- Office expenses, such as supplies, utilities, telephone, etc.

- Salaries and salaries of office staff, vendors and owners.

- Tax on payroll and employee benefits.

- Advertising, promotional expenses and other sales expenses.

- Insurance.

- Professional fees.

- Rental.

Variable expenses are recorded as cost of merchandise sold. Fixed expenses are counted as operating expenses, sometimes called selling expenses and general administrative expenses.

Importance

Companies with higher gross profits have a competitive advantage over competitors.

This is because they may charge a higher price for products or services, as reflected in higher revenues, or because they pay less for direct costs, as reflected in lower costs for merchandise sold.

Gross profit can be used to calculate gross profit margin. Expressed as a percentage of revenue, this indicator is useful for comparing a company's production efficiency over time.

Simply comparing gross profit from year to year or quarter to quarter can be misleading, as gross profit can increase while gross profit margins decrease.

How is it calculated?

One of the important financial concepts for running a business is calculating gross profit. It is calculated as:

Total sales - Cost of merchandise sold = Gross profit.

To calculate the total sales amount, the company must total all the products sold during the chosen financial time period. This total should not contain the sale of fixed assets, such as machines or buildings.

For example, a shoe store will have as total sales the total amount of money received from the sale of shoes from its inventory.

To compute the cost of merchandise sold, all costs involved in selling shoes to customers must be added. Only variable costs will be taken, such as:

- Salaries of sales staff.

- Cost of buying the shoes sold.

- Commission to sales staff for meeting objectives.

- Shipping of sold shoes, if purchased online.

- Credit card charges for customer purchases.

While gross profit is a money value, gross profit margin is expressed as a percentage. It is calculated as follows:

Gross Profit / Sales = Gross Profit Margin.

Differences with net income

Gross profit is sales revenue less the cost of merchandise sold. The term net income could have a variety of definitions.

Net income is assumed to mean all income less all expenses, including cost of merchandise sold, selling, general and administrative expenses, and non-operating expenses.

In a corporation it can also mean profit after income tax expense.

It is important to realize that gross profit is the amount before deducting expenses, such as sales, general and administrative, and interest. In other words, there is a big difference between gross profit and net profit.

Gross profit should not be confused with operating profit, also known as earnings before interest and taxes, which is the profit of a business before taking into account interest and taxes. Operating profit is calculated by subtracting operating expenses from gross profit.

Examples

Gross profit is the difference between the cost of producing or purchasing an item and its selling price.

For example, if for a company the cost of manufacturing a product is $ 28 and the product sells for $ 40, the gross profit of the product is $ 12 ($ 40 minus $ 28), or 30% of the selling price ($ 12 / $ 40).

Similarly, if a retailer has net sales of $ 40,000 and its cost of merchandise sold was $ 24,000, gross profit is $ 16,000, or 40% of net sales ($ 16,000 / $ 40,000).

Ford Motor

Using Ford Motor Co.'s 2016 Annual Income Statement, you need to calculate gross profit and gross profit margin:

To calculate gross profit, first you take the cost of selling the cars, which amounts to $ 126,584. Selling, administrative and other expenses are not included, as these are mostly fixed costs.

Then this cost of selling the cars is subtracted from the income, to obtain a gross profit of $ 151,800 - $ 126,584 = $ 25,216 million.

To obtain the gross profit margin, this gross profit is divided by the total income, for a margin of $ 25,216 / $ 151,800 = 16.61%.

This compares favorably with the average for the auto industry, which is around 14%. This suggests that Ford operates more efficiently than its competitors.

References

1. Investopedia (2018). Gross Profit. Taken from: investopedia.com.
2. Investing Answers (2018). Gross Profit. Taken from: investinganswers.com.
3. Entrepreneur (2013). How to Calculate Gross Profit. Taken from: entrepreneur.com.
4. Shopify (2018). Gross Profit. Taken from: shopify.com.
5. Harold Averkamp (2018). What is gross margin? Accounting Coach. Taken from: accountingcoach.com.