Understanding Gross Profit and its Calculation with Formulae
Every commercial establishment earns a profit but incurs some expenses. Profit is the overall revenue earned from running a business, which may be the production or sale of goods and services. There are two heads on the income side –net profit and gross profit (GP). Are these two different terms?
Gross Profit, sales profit, or gross income is the organization's earnings after deducting selling or production costs. Accountants also refer to it as sales profit or gross income. To calculate the gross profit, the accountant considers the total amount earned on selling the product after deducting the cost of raw material and other production costs, including labor, and the price of selling the produce.
These expenses are the cost of goods sold (COGS). Although a business incurs many other expenses, such as office furniture and fixtures, these do not become a part of COGS. And thus are deducted.
EXAMPLE
Suresh runs a fast food cart by the roadside; he sells sandwiches for INR 30. He finished the day with INR 5000 in hand, and the bread and all other ingredients cost INR 1,500. Since he is a sole proprietor and does not charge a salary for making sandwiches, what is his one-day gross profit?
The formula is:
| Gross Profit = Total Revenue – Cost Price Of Sandwiches 3500 = 5000 – 1500 |
Takeaway
Gross profit is like delivering content as a freelancer.
So, what is the gross profit of a freelancer? Don't consider the sunk cost, which is why there is no need to consider the cost of the laptop or the software. But take the internet charges into account. So a freelancer's gross profit is the content's cost minus internet cost.
For instance, if the content earns INR 1000 and the internet cost for research and submission is INR 50, the gross profit of the freelance content writer is INR 950.
What Is Gross Profit?
Any business cannot create its merchandise at zero costs, and they need to buy the raw material and pay the labor cost for converting it into finished goods ready for sale. Thus, gross profit is the money left in hand after deducting the amount the business spends on the final product manufacture. Some accounting systems also remove freight and factory overheads to compute gross income from the revenue.
On selling the produce, a business does derive a sales figure, but that cannot be the profit for the business incurred, for there is a need for expense deductions. Gross income, therefore, provides the exact earnings or the sales success of a business.
Gross Profit Vs. Gross Margin
The two terms are similar but not the same. The similarities of the terms encourage people to use them interchangeably; however, that isn't correct.
Here is the primary difference:
The former is the difference between the cost of the product and its selling price, while the latter is the sale of a product.
Difference Between Gross Profit and Net Profit Margin
Although the two variables are similar in that a ratio expresses them as percentages or profitability ratios that indicate the business's financial health, there imply two different things. Net profit margin is a better metric to measure profit because it considers all business expenses, not just the COGS.
Meanwhile, gross profit computation involves the division of sales Profit by net sales after deducting the cost price of the sold goods multiplied by 100.
The formula is as follows,
| Gross Profit Ratio = The Net Sales - COGS / Net Sales |
What Is A Good Gross Profit Margin?
Although a margin of 50 to 70% sounds good, it is better to accept that the figures cannot be the ideal margin for all enterprises, irrespective of their industry. Some sectors have more expenses while others have almost zero; thus, their margin will be high, even up to 90%.
For instance, a sugar factory must buy raw materials before producing sugar, and the raw material costs will bring down the margin. What if the business is a law firm where there is no need for raw materials? They will earn at a higher margin.
How Do You Calculate the Gross Profit?
As discussed earlier, gross profit is business revenue after COGS or operating cost deduction. Let us know the three variables better:
COGS
These are direct costs incurred by the business to produce the marketable finished product and include:
- Consultation is provided to the customer to personalize the product and teach them to use it.
- All materials necessary for production, including raw materials
- Labor costs
- Direct shipping costs (e.g., raw material shipping costs)
- Utilities used for production
- Cost of equipment for production purposes
Revenue
It is the sum of money that comes into the business on the sale of the product and does not include indirect expenses such as taxes.
Gross Profit Calculation–Formula
| Gross profit = Total Revenue - COGS |
Limitations Of Using Gross Profit
Gross profit is a vital cost-efficiency metric that reports the direct expenses of the business over a specific period. However, gross profit does have disadvantages which are as follows:
- Gross profit excludes indirect costs such as electric charges, rent for premises, salaries to staff, etc. Thus, the operational efficiency metric may be inaccurate.
- The cost structure varies across industries; it, therefore, cannot be used as a benchmark for gross profit determination or industry comparison.
Conclusion
The calculation is simple; however, it is essential to understand how its analysis helps a business. Gross profit is the metric that tells a company if their efficiency levels in production are adequate or need improvisation.
FAQ
What is the procedure for calculating Gross profit?
The gross profit is the margin between sales and cost of goods sold (COGS). It is figured out by deducting COGS from revenue. Accountants also refer to it as sales profit or gross profit. The income statement of a business will contain these numbers. The calculation is simple.
First, you calculate all the COGS. While adding the COGS, don't include fixed costs such as administrative or selling costs. Finally, subtract the revenue from the sale of goods. The resultant sum is the gross profit.
What does the term gross profit refer to?
Gross profit is an income and thus appears on the income side of the financial statement. It is the amount a company retains after deducting the expenses incurred in producing and offering its goods or services.
It is the earnings of a business from the production and sale of goods. The calculation of gross profit is simple. You may determine gross profit by subtracting the cost of goods sold (COGS) from your total sales.
What Is the Difference Between Gross Profit and Net Profit?
The gross profit tells a business how much revenue it earns from producing and selling its products. It is the difference between the COGS or the money spent in producing and selling a product and the revenue from its sale and helps stakeholders estimate the earning capacity of a business.
Net profit is the total earnings or profitability of a business. The sum is derived after deducting expenses and costs from the total sale revenue. Therefore, compute your earnings before deducting expenses to determine your gross profit. Subtract all expenses from your incoming revenue to arrive at your net profit.
Please provide an example for gross income calculation.
The cost of goods sold (COGS) is deducted from the revenue to obtain the gross profit. For instance, if XYZ Ltd. spent a total of $8000 in the production of a product, it would be the COGS, and if they earned a sale revenue of $20000 as sales proceeds from the same, its gross profit is $12,000. It involves a simple calculation whereby the total COGS is deducted from the total sale revenue.
Why is Gross Profit a Valuable Metric?
When evaluating a company's operational effectiveness and financial performance, it's critical to consider gross profit. The ability of a business to utilize its resources, such as raw materials, labor, and other suppliers, is shown by its gross profit.