What Is Gross Profit
Gross profit or gross income is one of the main indicators characterizing the results of the company's business activities. The price of goods (works, services) sold is linked with investments in their cost. GP reflects sales profitability and allows you to determine how rationally each resource is used.
Gross Profit Definition
Gross profit is the excess of sales over variable costs. It is known that variable costs for an enterprise are costs that change due to changes in production volumes.
The calculation of GP allows you to highlight promising areas of economic activity and redistribute financial flows to obtain a more effective result. It is especially relevant with a relatively small share of administrative and commercial expenses. If they make up no more than 5% of the total cost, then it is recommended to use this indicator for short-term and medium-term planning. In the case of long-term planning, it is rational to calculate other types of profit, such as marginal profit.
You can also use GP when preparing budgets and cash flows for the next period. It is worth remembering that this type of profit is close to production and does not reflect, for example, advertising costs. Therefore, for the final budget, it will not be enough to analyze only GP.
For more information on gross income and other economic terms, refer to Monfex.com.
Gross Profit Calculation Example
Let’s suppose that we have the following data for the calculation of GP:
- the sales price of products - $6;
- total sales - 520,000 units;
- inventory levels at the beginning of the reporting period - 40,000;
- inventory levels at the end of the reporting period - 60,000;
- variable costs of making one product - $4;
- variable trading costs for sales - $1,20;
- fixed production costs - 200,000;
- trade and administrative expenses - 80,000.
According to this data, it is necessary to determine:
- Quantity of products for a certain period of time:
- sales volume - 520,000 units;
- inventory levels at the end of the reporting period - 60,000 units;
- required quantity of goods - 580,000 pcs;
- inventory levels at the beginning of the reporting period - 40,000 units;
- production - 540,000 pcs.
- sales revenue (520,000 * 6) = 3,120,000;
- minus the variable part of the cost of goods sold;
- a) inventory levels at the beginning of the reporting period (40,000 * 4) = 160,000;
- b) variable part of the production cost (540,000 * 4) = 2,160,000;
- c) variable part of the cost of goods (580,000 * 4) = 2,320,000;
- d) net of inventory levels at the end of the reporting period (60,000 * 4) = 240,000.
The gross profit of the manufacturer is 1,040,000. Subtracting variable trade and administrative expenses (520,000 - 1,20) = 624,000.
GP is 416,000. With the exception of fixed costs:
- a) overhead - 200,000;
- b) trade and administrative expenses - 80,000.
How to Manage Gross Profit
Management of GP occurs through the impact on revenue and cost. You can manage gross income in the following ways:
- Increase sales
- Manage the product range
- Look for new sales channels
- Find ways to reduce the cost of production through more profitable raw materials
- Change processes
- Increase the productivity of employees of production lines
- Reduce general business expenses as well as the costs of electricity, gas, or water
What Is Gross Profit Margin
The GP margin expresses a company's pre-tax profit over a period of time as a percentage of total revenue. The gross margin is calculated according to this formula: net revenue - production costs * 100 / net revenue. The GP margin is an important measure of a company's profitability.
For example, if the net revenue is $45,500 and the COGS is $30,500, then the GP margin will be calculated as follows:
($45,500 - $30,500) * 100 / $30,500 = 49%
Let’s consider one more example to get a better understanding of what is gross profit margin. Let’s suppose that two companies produce sportswear. If Company A can produce sports T-shirts for one third of the cost during the same time period, it means that this company is more successful in the industry than its competitors. Their competitor, Company B, has decided to reduce the cost of goods sold by three times but double the sales price to compensate for the margin loss. As a result, the sales price has grown but the demand has dropped because no one wants to pay twice as much as the previous price. So Company B has lost its market share and GP margin.
What Is the Difference Between Gross Profit and Net Profit?
Regardless of the context, gross figures are always used in the calculation of the net numbers. Net income calculations begin with gross income before deducting business expenses. Business expenses can be broken down into different types, including COGS, operating costs, interest paid, repairs and maintenance, etc.
Gross income is one of the simplest and most basic figures in analyzing a business and its revenue potential. Like many simple financial figures, gross income is most useful when it comes to the industry, as gross revenues vary widely by industry. Under certain circumstances, the gross income is presented as total income minus the cost of goods sold.
Net income is another simple indicator used to analyze a company's overall financial state. Net income typically requires two critical aspects: industry knowledge and individual enterprise income development based on past performance. In short, you want net revenue to increase over time and be relatively high as compared to competitors.
The Bottom Line
Now you are aware of what is gross profit, what is gross profit margin, and what is the difference between gross profit and net profit. Stay tuned with more financial definitions at https://www.monfex.com/financial-dictionary