What is Gross Profit?

What is Gross Profit?

Gross profit is net sales minus the cost of goods sold. It reveals the amount that a business earns from the sale of its goods and services before the application of selling and administrative expenses. Gross profit is typically stated partway down the income statement, prior to a listing of selling, general, and administrative expenses.

Gross Profit Formula

The gross profit formula requires you to subtract all costs associated with the production of goods or services from revenue. These costs include direct materials, direct labor, and factory overhead. The calculation is as follows:

Revenue – (Direct materials + Direct labor + Factory overhead)

What Gross Profit Can Tell You

Gross profit assesses a company’s efficiency at using its labor and supplies in producing goods or services. The metric mostly looks at variable costs—that is, costs that fluctuate with the level of output, such as:

  • Materials
  • Direct labor, assuming it is hourly or otherwise dependent on output levels
  • Commissions for sales staff
  • Credit card fees on customer purchases
  • Equipment, perhaps including usage-based depreciation
  • Utilities for the production site
  • Shipping

As generally defined, gross profit does not include fixed costs (that is, costs that must be paid regardless of the level of output). Fixed costs include rent, advertising, insurance, salaries for employees not directly involved in the production, and office supplies.

However, it should be noted that a portion of the fixed cost is assigned to each unit of production under absorption costing, which is required for external reporting under the generally accepted accounting principles (GAAP).

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For example, if a factory produces 10,000 widgets in a given period, and the company pays $30,000 in rent for the building, a cost of $3 would be attributed to each widget under absorption costing.

Gross profit shouldn’t be confused with operating profit. Operating profit is calculated by subtracting operating expenses from gross profit.

Limitations of Using Gross Profit

Standardized income statements prepared by financial data services may give slightly different gross profits. These statements conveniently display gross profits as a separate line item, but they are only available for public companies.

Investors reviewing private companies’ income should familiarize themselves with the cost and expense items on a non-standardized balance sheet that may or may not factor into gross profit calculations.

What Is an Example of Gross Profit?

Consider the following quarterly income statement where a company has $100,000 in revenues and $75,000 in cost of goods sold. Importantly, under expenses, your calculation would not include any selling, general, and administrative (SG&A) expenses. To arrive at the gross profit total, the $100,000 in revenues would subtract $75,000 in cost of goods sold to equal $25,000.