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If you’ve taken on a buy-and-hold style of investing, then you might need to spend a bit of time understanding earnings statements.
Even though they’re a bit daunting to read, understanding some of the most basic terms can help you at least put together a rough picture of the company’s financial health.
One figure that can be easily misunderstood is the gross profit. This might seem simple to those familiar with terms like “gross” and “net,” but jumping to conclusions will lead to confusion.
Let’s explain what gross profit is because chances are, it’s not what you think.
What is Gross Profit?
Gross profit is the total profit it makes on the sales of either goods or services after subtracting the costs of producing those goods or services.
Understanding Gross Profit
It might help to break down this term into two parts then put them together. First, “gross” means the total amount without any subtractions.
“Profit” can be confusing because you subtract something from a “gross” figure to get profit. Profit is the selling price of an item less the cost of producing it.
So, gross profit is the total sales revenue made from a service product less the production and distribution costs.
In the case of service companies, gross profit is the total sales less the costs of providing the service.
It may seem logical to assume that net profit or net income is derived from gross profit. It is, in a way, but net profit is the total profit from all revenue streams, whereas gross profit is focused on revenue from its products and services.
>> More: What Is Operating Revenue?
How to Calculate Gross Profit
Calculating gross profit is relatively simple, but it can be complicated depending on how a company makes its money.
For the sake of simplicity, here is the formula for gross profit of a simple company, like a small t-shirt selling operation.
Gross Profit = Total Revenue – Cost of materials and production – the cost of shipping
What is the Importance of Gross Profit?
Companies use gross profit as a sort of grade that tells how efficient they are at providing their goods or services. It is a good indicator of the efficiency of their operations.
If a company sells a product for $100, but it costs $99 to produce, their profit would be $1 for every unit sold.
The resulting gross profit on all their units sold would then tell the company that 1.) they’re spending too much on production or 2.) they need to increase the selling price.
Gross profit is also used to figure out a company’s profit margin. Gross profit is represented as a dollar figure, whereas the profit margin is represented as a percentage.
Gross Profit FAQs
What is Gross Profit?
Gross profit is the revenue of goods and services sold less the cost of goods sold (COGS). It provides companies with a metric showing how efficient it is at producing the goods or services it sells.
It can also be used to find out the company’s profit margin on a particular product.
>> More: Earnings vs. Revenue
Is Gross Profit Always Calculated the Same Way?
The formula for calculating gross profit is always the same. However, companies can sometimes get creative about how they define “sold.”
For companies that operate with long-term production contracts, they might count goods sold once they receive payment for a predefined set of units that depart the production facility to the customer, or they might define the products as sold once they receive payment for a set of units before the units are actually completed.
Also, the Cost of Goods Sold (COGS), which is the other part of the gross profit formula, can be complicated.
COGS would typically be costs that are both required specifically for producing the product and variable.
Rent of a facility would not be an example of a variable cost. However, some accounting principles allow the cost of rent for a reporting period to be distributed equally among the units reported as sold in that period.
>> More: What Is Net Income?
Where Can I Find Gross Profit on the Income Statement?
Gross profit will be found in the consolidated statements of operations (or some modification of this), showing the accounting figures as line items. It is usually the heading of a financial statement.
Gross profit could also be called gross margin, and it is typically found near the top of the consolidated statements.
>> More: Gross Profit vs. Net Income
Bottom Line: Gross Profit Definition
Gross profit is an important indication of how efficient a company is at using its resources to make its products or provide its services.
While the formula is basically the same – just subtract the cost of goods sold from revenues – the two parts of the formula are different for almost every company.
Some very strict rules go into each figure in the financial statement, but companies will develop a method and apply it the same way across the board to avoid misrepresenting their financial health.