Gross margin, operating profit and net profit

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The terms “profit” and “income” are often used interchangeably in everyday life. In corporate finance, however, these terms can have very different and specific meanings, depending on the context in which they are used.

While income means positive cash flow in a business, net income is something much more complex. Profit is generally understood to refer to the money that is left after the expense is recognized. Although gross profit and operating profit both fit this definition in the simplest sense, the types of income and expense considered differ significantly.

Key points to remember

  • Gross profit is total income less expenses directly related to the production of goods intended for sale, called cost of goods sold.
  • Derived from gross profit, operating profit reflects the residual income that remains after taking into account all operating costs.
  • Net income reflects the total residual income that remains after accounting for all cash flows, both positive and negative.

Understanding net profit, gross profit and operating profit

Gross profit, operating profit, and net profit are all types of income that a business generates. However, each metric represents profit at different parts of the production cycle and profit process. The three financial measures are located in a company’s income statement and the order in which they appear helps to show the relationships with each other and their importance.

The top line of the income statement reflects the gross turnover of a business or the total amount of income generated from the sale of goods or services. From there, various expenses and alternative income sources are added and subtracted to arrive at the different profit levels.

Gross profit

Gross profit is total income minus only the expenses directly related to the production of goods intended for sale, known as cost of goods sold (COGS). COGS represents direct labor, direct materials or raw materials, and a portion of the manufacturing overhead costs associated with the production facility.

The COGS does not include indirect expenses, such as the cost of the head office. COGS is a key metric because it has a direct impact on a company’s gross profit, which is calculated as follows:

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Since COGS represents the cost of acquiring inventory and manufacturing products, gross margin reflects the revenue remaining to finance the business after recording production costs.

Although gross profit is technically a net measure of profit, it is referred to as gross because it does not include expenses related to debt, taxes, or any other expenses involved in running the business.

Operating profit

The operating result then comes to the income statement. Derived from gross profit, operating profit reflects the residual income that remains after taking into account all operating costs. In addition to COGS, this includes fixed-cost expenses such as rent and insurance, variable expenses, such as shipping and freight, payroll and utilities, and depreciation and depreciation of assets. active. All expenses necessary for the proper functioning of the business must be included.

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However, like gross margin, operating income does not take into account the cost of interest payments on debts, tax burden or additional income from investments. Operating profit reflects the profitability of a company’s operations.

Operating profit is also called earnings before interest and taxes (EBIT). However, EBIT may include non-operating income, which is not included in operating income. If a company does not have non-operating revenue, EBIT and operating profit will be the same.

Net revenue

The profit of a business is called net income or net profit. Since net income is the last row at the bottom of the income statement, it is also called the bottom row.

Net income reflects the total residual income that remains after accounting for all cash flows, both positive and negative. In other words, from the income, called the front line number, all income, expenses and costs are deducted to get the net income.

From the operating profit figure, debt expenses such as loan interest, taxes, and one-off entries for unusual expenses such as lawsuits or equipment purchases are all subtracted. Any additional income from side operations or investments and one-off payments for things like selling assets are added.

Net income is arguably the most important financial metric, reflecting a company’s ability to generate profits for owners and shareholders.

Example of gross and operating profit and net profit

Below is a sample income statement to illustrate the differences and locations of the three measures of profitability.

Gross profit (labeled as gross revenue) was $ 3 million for the quarter (or revenue of $ 5 million minus $ 2 million in COGS).

Operating result was $ 2.2 million for the period, which is calculated by taking gross profit of $ 3 million less operating expenses of $ 1 million (total expenses labeled). However, we have to add back the interest expense of $ 200,000 because operating profit does not include interest (or $ 3 million – $ 1 million + $ 200,000 = $ 2.2 million).

Net revenue was $ 1.5 million for the period, which is located at the bottom of the income statement.

Image by Sabrina Jiang © Investopedia 2020


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