When approaching the concept of profit, many business people can focus on the total amount of revenue that they’re bringing in. They might look at that income statement, skip right on past to the net income part. Then determine whether they’re profitable, and call it a day.

But there are a variety of different facets to profit. Each one of them can tell you a whole host of things about your business. One such facet is gross profit. Examining gross profit can clue you in on how effective your business’s methods of production are. This also includes understanding what goes into the gross profit equation.

What Is Gross Profit?

 

Gross profit is also known as sales profit and gross income. It reveals the amount of money that a business earns from the sale of its goods and services. This is before operating costs or selling and includes administrative expenses. In other words, gross profit is the revenue a company has left over. Or what’s left after it pays the costs associated with making and selling a product.

Adjustable costs such as direct labor, shipping fees, and equipment, all go into determining the cost aspect of gross profit. This also includes sales commissions, project materials, and production sites utilities. Fixed costs such as salaries, rent, advertising, insurance, and office supplies are not part of the gross profit equation. Basically, if it’s something that doesn’t directly deal with sales or production, it’s not part of the gross profit.

What Goes into Calculating Gross Profit Equation?

The gross profit equation is net sales minus the cost of goods sold. It may seem like a fairly straightforward enough equation. But what goes into actually calculating it for a particular period?

First, you need to arrive at your net sales figure. You do it by collecting your gross sales information. As well as all deductions from sales, such as sales discounts and allowances. Then, you need to collect information relating to the costs of goods sold. This requires you to consistently and thoroughly examine your expense account information.

 

After this, you need to determine factory overhead costs. Or costs incurred during production. Again, this is going through the detailed examination of your accounts.

 

Subtract the direct cost of goods sold and the factory overhead charged to the cost of goods sold from net sales. Then, you’ll get your gross profit for a particular period.

Understanding Operating Profit

 

To better understand what exactly gross profit is, it’s also helpful to look at what it isn’t. To do this, we should look at operating profit. It means operating income or earnings before interest and taxes (EBIT). Operating profit does offer a more narrow determination of a company’s profitability than gross profit would. It measures the efficiency of the core business by removing costs of production.

The operating profit equation is gross profit minus operating expenses. Gross profit is revenue minus cost of goods sold. The number you’re left with measures the profit earned through a company’s recurring business operations. This is excluding any extraordinary income and expenses such as taxes. The same with interest payments, and any outside company investments.

 

To calculate your operating profit margin, you divide operating income by net sales revenue. This is helpful in measuring your return on sales.

Why Is Gross Profit Important?

Gross profit is important. It is a preliminary reflection of the core profitability of a company. It also demonstrates the financial success of a product or service.

Gross profit can also be useful to calculate the gross profit margin. This gives you an idea of your company’s production efficiency over time. Expressed as a percentage, divide the gross product by the cost of goods sold to get the gross profit margin.

High-Profit Gross Margin

If your business has a high gross profit margin, then it can gain a significant advantage over the competition because a high gross profit margin means that you either paid less for direct cost and that you can also potentially charge a higher price for your goods and services.

 

It’s important to note that gross profit margins do differ depending on what industry you’re in. For example, construction companies and convenience stores tend to have lower profit margins, while banks and healthcare companies lean towards higher profit margins.

 

If you want a better idea of why certain industries are more competitive and achieve high-profit margins than others, an analytical framework known as Porter’s 5 Forces breaks this down in a little more depth. But, ultimately, you just want to keep in mind what industry you’re in and who your competitors are when calculating gross profit margin.

 

Don’t Grossly Underestimate Gross Profit

While gross profit may offer a somewhat rudimentary prognosis of your company’s profitability, it’s important to understand what it really is and what goes into calculating it so that you can better comprehend your company’s financial condition.

 

Sure, it’s only one variable to look at when determining profitability, but your company may struggle to achieve peak success if every variable is not treated with significance.

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