Gross profit, also known as gross income, is the amount of income that remains after subtracting the direct costs of providing a product or service. Investors assess a company’s gross profit to understand whether the company is able to charge higher prices or prices that barely cover the direct costs of the product or service.
These direct costs associated with making a product or providing a service are known as cost of goods sold, or COGS. Gross profit is simply equal to revenue minus COGS.
Example of gross profit
Let’s go through an example to better understand the gross margin and how it is calculated.
|Subcontracting services||$ 3,000,000|
|Cost of goods sold
|Gross profit||$ 3,000,000|
This company has a turnover of 10 million dollars. The direct costs – those associated with manufacturing the product – are $ 7 million. Subtracting $ 7 million from $ 10 million gives a gross profit for the business of $ 3 million.
Gross profit of $ 3 million on $ 10 million in revenue equates to a gross margin of 30%. While the gross margin is the amount of money in absolute terms that is left after subtracting the COGS, the gross profit margin is the gross margin as a percentage of sales.
Understanding the gross margin
Since gross profit is an absolute number, it is somewhat less useful as a comparison tool for investors than gross profit, which is a percentage. Investors can more easily use the gross profit margin measure to analyze and compare companies.
However, you can better understand a company’s gross profit by taking a close look at its COGS. Product companies generally have a higher cost price than service companies, which means that product companies generally have lower gross profits. But service companies generally have higher operating expenses than product companies, so higher gross profits are needed for service companies to pay fixed costs such as insurance or marketing.
If two similar companies with similar revenues have very different gross profits, then the company with the higher gross profit probably has a significant competitive advantage. If a company’s revenue over time remains constant but its gross margin decreases sharply, then one or more of its direct costs have increased significantly. Sometimes a company’s COGS remains constant, but its gross margin declines because the price the business is able to charge for its product or service has dropped significantly.
After gross margin on the balance sheet
After gross margin, investors calculate operating profit. The operating profit of a company is its gross margin less its fixed costs. Costs are fixed if they do not vary with the amount of a product or service provided by the business. Usually, the largest fixed costs are related to management and administration, sales, research and development, as well as rent and utilities.
After operating profit, investors calculate net profit, otherwise known as net profit. Net income is operating income less all non-operating expenses such as taxes and interest.
While both a company’s operating profit and a company’s bottom line are important, companies with high gross profits tend to perform best. High gross profit means that there is plenty of money left to pay for the overhead and non-operating expenses of the business.