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GROSS PROFIT

Gross Profit

Gross profit is calculated by deducting the cost of goods/services sold from the revenue of the company. In other words a company’s gross profit is its revenue minus the cost incurred due to the production of a product or providing a service.  This is found in the company’s income statement for that particular period.

Formula and example

Gross Profit = Revenue- COGS

Gross profit = Sales- COGS

COGS→ Cost of goods sold

If a company has revenue of 1 million and COGS is 600 grands, then the gross profit is 400 grands.

Gross profit= 1000000-600000=400000


Significance and impact

Gross profit means, how much money the company is actually making after meeting overheads of production of products. If the company is not left with much of gross profit after meeting cost of goods sold, then company has to introspect seriously on how to bring the cost down. No to forget there are other deductions like tax, depreciation and amortisation before arriving at the net profit. Gross profit is also referred as gross income or sales profit. The gross profit included only the deductions of variable cost and not the fixed cost. The fixed costs like salaries, rent, advertising which are invariably incurred by the company are not included in the COGS to arrive at gross profit. Overall it gross profit paints the efficiency of company is utilising its resources for running business. 

Difference between gross profit and gross profit margin

There is a thin line between gross profit and gross margin and often are used by mistake. No doubts both are concerned with the similar metrics but these two are different parameters. Gross margin is the percentage of comparison of product cost to product’s sales price whereas gross profit is the also a percentage but of the profit earned by the sale of product. 

To arrive at the gross margin, the gross profit is divided the total sales.

Gross margin = (Sales-COGS)/Sales   or

Gross margin = Gross profit/sales

For the above example where gross profit was 400000, the gross margin will be

Gross margin = 400000/1000000=40%

Both Gross profit and gross margin are good indicators of the profitability of the company but it will be bit harsh to compare two different companies on the same parameters. This is because both the metrics doesn’t consider the fixed overheads incurred by the companies to derive the net income. 

Consider two companies in same business which has different gross margin. It is not justified to rule out company with lower gross margin and consider the other as better performing company for the reason that company with higher gross margin might have higher fixed overheads. There is probability that both companies have the same net income and profitability in the end after considering tax, salaries and interest payments. Analysts often thus doesn’t rely solely on gross margin as it might be misleading. They use a set of financial ratios to judge the health of the company and its ability to continuously run the business. Perpetuity is the clause for any company doing business. To study the historical track record of the company and to see if there is any sudden dip or fall in the gross margin is one of the main considerations.

Importance of Gross profit

Gross profit has a significant impact during the analysis of profitability of the company. It is also an important parameter to judge the financial performance of company across the timeline. Gross profit is an indicator of company’s management’s efficiency. It depicts how effectively the management are utilizing the resources (human power, raw materials, production system) of the company in the production. 

Gross profit measures how well the company is undergoing production of goods. Higher the revenue and lower the production costs, profits will be peaks. Thus to increase the profits, a company should always try to lower the cost of production without being able to compromise for the quality of production. The GP is important because ultimate net income is a derivative of gross profit and higher the gross profit, the better it is for the net income. Companies will also have the cushion of flexible product price and can tweak the end price of product only if the gross profit is high.

Advantages of gross profit

• Gross profit is easy to estimate and use to make decision related to the running the business in an efficient manner.

• Gross profit method of inventory management is effective in case of huge firms such as Walmart and amazon, where the size of inventory is large and difficult to track on regular basis.

• It is a very handy parameter while preparing the budget for the inventory management.

• Auditors use gross profit to validate and verify the inventory held by the company throughout the year and also while preparing the periodic financial statements of the company.

• Companies need not count the inventories every now and then as it is time consuming and might hamper the production process.

Disadvantages of gross profit

• The main disadvantage is that the gross profit is not the actual measure of profitability.

• Gross profit considers only the variable costs and ignores the fixed cost due to which exact profitability cannot be predicted. For this reason it can be used to estimate the cost of operation as percentage of sales.

• There is no optimum gross profit percentage pertaining to any company. A company with highest gross profit can still not be doing well and have poor financial health.

• Even though the term profit exists in gross profit, it is not profit but a factor out of which net income of a company can be obtained.

Conclusion

Gross profit is an important factor in judging the effectiveness of production line in a company. It can also be used to optimize the profits to maximum. It gives the management the idea to bring down the cost of production without compromising for quality and still increase the profitability of the company. Even though it is the initial factor out of which net income is derived, should not be used as actual profit because of its deceptive nature due to fixed costs. In a nutshell gross profit gives the efficiency of the management of the company and to what extent the resources (human resource and inventory) are utilised effectively.



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