Calculating the gross profit is the first step in the analysis of the company’s profitability. That tells you how profitable the company’s production is. But it’s not a complete picture to assess the profitability of a company. Factors such as the efficiency of production, competition level, and accounting practices can significantly affect the numbers. Also, the figure varies between industries.
What is gross profit
Gross profit equals profit remained after deducting revenue from the cost of goods sold. It shows the profit remaining after reducing expenses directly related to the production and sale of products or provision of services.
To produce products, companies use some inputs, such as employees who operate machinery and raw materials. These inputs are mostly variable costs, in a sense, their increase or decrease will be in line with the level of output.
Ideally, the company will record a sizeable gross profit relative to sales revenue. That way, they can cover other operating expenses profitably. These operating expenses include sales, general and administrative expenses. The sum of the three is what we call the operating expenses.
Operating expenses are usually mostly fixed expenses. That is, the company must pay, regardless of the level of production. An example is non-production employees’ salaries, rent, advertising, and office equipment.
Where do you find the gross profit
Public companies usually present it as a separate item, below the cost of goods sold on the income statement. You can also find detailed figures in the notes section of the financial statement.
But, some companies, especially private companies, might not present it in the financial statements. They are not bound by financial reporting standards. Therefore, in this case, you have to calculate it yourself.
How to calculate gross profit
You can calculate the gross profit by subtracting revenue from cost of goods sold (COGS). The following is the formula:
Gross profit = Sales revenue – COGS
I will briefly discuss the components.
Sales revenue represents the revenue the company receives after reducing it with components such as discounts and sales allowances. You need to remember, revenue is not the same as the actual money the company makes.
In accrual accounting, companies can record revenue even though they have not received payment. It’s common if the company sells products on credit. Instead, the company will record it in the accounts receivable —the higher the value of accounts receivable, the larger the unpaid goods.
The cost of goods sold (COGS) covers various direct costs to produce and sell products. That includes:
- Direct labor
- Raw materials
- Costs of equipment used in production
- Utilities for production facilities
- Cost of repairs
- Shipping costs
You can calculate the cost of goods sold by adding up those expenses. Alternatively, you can also calculate the cost of goods sold using the formula:
COGS = Initial inventory – End inventory + Purchases
Let’s take a simple example.
Within a year, a manufacturing company sells 100 units of goods at a price of Rp10. Due to some problematic products, the company also provides a reduction in selling price (sales allowance), which totals Rp100. The company also spent Rp400 on raw materials, labor, and several other input components. As a result, the company’s gross profit is IDR 500 [(10 units x IDR 10) – IDR 100 – IDR 400].
One more example.
A company buys inventory for Rp1,500. The company reports an initial inventory of Rp1,500 and an ending inventory of Rp2,000. Of sales, the company posts revenue totaling Rp3,000.
In the case above, the cost of goods sold during the period is Rp1,000 (Rp1,500 – Rp2,000 + Rp1,500). Hence, the company’s gross profit equals Rp2,000 (Rp3,000-Rp1,000).
What are the factors affecting gross profit
From your calculations, you know that gross profit depends on two variables, namely sales revenue and cost of goods sold. To answer why gross profit increases or decreases, you can break down the determinants of both variables.
- Sales revenue is a function of units sold and price. Apart from that, it also depends on factors such as discounts and sales allowances. You should also examine sales from each product segment.
- The cost of goods sold consists of many aspects, from labor costs to factory overhead. Technological factors also affect production efficiency.
Well, I will briefly discuss the factors that cause gross profit to decrease.
- Declined units sold. This causes a decrease in revenue, assuming the company still maintains the same selling price. Consumers turn to competitor’s products, maybe, because of lower prices or better quality. It is also common during the weakened market demand period (such as a recession).
- Lower price. Companies reduce selling prices or offer discounts to attract more purchases. But that doesn’t always work. As a result, sales volume stagnated, but prices fell.
- Pile of goods in the warehouse. Sales may not be on target, and the information does not flow to the production department. As a result, the company is still producing normally. That results in a buildup of goods in the warehouse.
- Increased competition. Companies cannot raise prices immediately when competition increases. Instead, they will usually cut prices to maintain a customer base and market share. Lower prices mean less sales revenue.
- Increase in input prices. An increase in the minimum wage, raw materials, and energy increases the cost of goods sold.
- Weak economic conditions. When a recession, for example, consumer purchasing power falls. That weakens the demand for products.
How to calculate net profit from gross profit
How much profit does the company earn in one year? You can see it in the net profit section, not on the gross profit number.
As the definition above, gross profit is the difference between sales revenue and cost of goods sold. If you reduce it by selling, general and administrative expenses, you get an operating profit figure. This number tells you how much the company makes a profit from its primary activity.
Next, the company also has other sources of income (expenses). Examples are income from the sale of fixed assets, exchange rate translation gains (losses), and interest income (expenses). Finally, the company also bears the tax burden. If you reduce net income with these components, then you get a net profit.
In short, the relationship between gross profit and net income can be seen from the following equation:
Net profit = Gross profit – Operating expenses – Other income – Other expenses – Tax expenses
Is net profit more important than gross profit
Some companies might make a gross profit. But, after being reduced by other operating expenses, the company posted a net loss.
Even though it doesn’t show the profitability that the company makes, that does not mean gross profit is unimportant. You could use it to calculate gross profit margins, which indicates the company’s competitiveness and efficiency in the market.
Also, the company uses the gross profit to assess performance and potential sources of profit in each segment. They can see which segments contribute more and which do not. It becomes an internal evaluation and management decision.
In conclusion, when you analyze a company’s financial statements, you need to use several metrics to evaluate whether the company is performing well or not.
What should you do after calculating gross profit
After getting the gross profit number, you can calculate other metrics, i.e., gross profit margins. This metric tells you how efficient the producer is in generating revenue.
Gross profit margin = Gross profit / Sales revenue
Its historical trends provide a more plausible picture than just looking at nominal gross profits from year to year. If the gross profit figure increases from year to year, but the margins fall, it indicates a problem in production efficiency.
You can also use gross profit margins to see the company’s competitive position. Increased competition pressure reduces margins because companies cannot increase prices carelessly. If they raise prices, consumers will switch to competing products.
Companies that have a competitive advantage will enjoy higher margins. They can charge higher prices (product differentiation) or are more efficient in production (cost leadership).
What are the limitations of gross profit
Gross profit does not tell you the profit the company made during the reporting period. This metric only measures how well sales revenue covers the direct costs of producing goods or providing services.
Also, gross profit varies among industries. Different accounting practices, especially in calculating the cost of goods sold, can affect its value. Therefore, the metric is only a small part of assessing the overall profitability of the company. You need to look at other parameters such as operating profit, net profit, operating profit margin, and net profit margin.