What is Gross Profit?
Gross profit refers to the earnings generated by a business after subtracting the expenses linked to manufacturing and distributing its products or services. To determine gross profit, subtract the total sales from the cost of goods sold (COGS), where total sales include all items sold excluding assets.
This figure indicates how efficiently a business employs its resources to manufacture goods or deliver services to its clientele. The business profitability and financial health heavily rely on this metric, and a decrease in gross profit typically signifies a reduction in the business earnings.
Nevertheless, its essential to recognise that gross profit doesnt take into account additional expenditures like operating costs, taxes, fixed costs, and interest. Therefore, it offers an incomplete assessment of a business overall profitability.
How to Calculate Gross Profit
Calculating gross profit is quite straightforward. Its the difference between the revenue a business earns from selling its products or services and the cost of producing or acquiring those goods.
To compute gross profit, first find the cost of goods sold (COGS). This involves tallying up all the expenses directly tied to making or obtaining the items for sale, which includes things like raw materials, labour costs, and any other overhead expenses related to production.
The formula for gross profit is simply:
Gross Profit = Total Revenue – Cost of Goods Sold (COGS)
Determining the COGS requires a bit more calculation. Start with the beginning inventory, add the purchases made during the period, and then subtract the ending inventory. This gives a clear picture of the direct costs associated with the goods that have been sold.
Once the COGS is calculated, gross profit formula can be used to find out how much profit the business has made from its operations.
Example:
For example, lets say a business that sells clothing makes $200,000 in revenue but incurs $120,000 in costs to produce those clothes. Using the formula:
Gross Profit = $200,000 − $120,000 = $80,000
This means the business has a gross profit of $80,000, which represents the money left over after covering the direct expenses of producing the goods. This amount can then be used to cover other operating costs and contribute to the overall profitability of the business.
AASB 102 outlines the principles for the valuation and measurement of inventories, which directly impact the determination of the cost of goods sold (COGS). This standard requires inventories to be measured at the lower of cost and net realisable value, with cost including all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
By adhering to AASB 102, entities ensure that the costs included in the COGS accurately reflect the direct costs associated with producing or acquiring goods for sale, thereby influencing the calculation of gross profit.
Apart from this, accurate revenue recognition practises, as guided by AASB standards such as AASB 118 and AASB 15, directly influence the calculation of gross profit and gross profit margin.
By recognising revenue when it is earned and realisable, entities ensure that gross profit reflects the true economic benefits derived from sales of goods or services.
The gross profit margin, which reflects the efficiency of a business operations in generating profit from its revenue, is therefore impacted by adherence to these standards. Transparent and accurate revenue recognition practises enhance the reliability and relevance of gross profit margin as a key performance indicator.
What is Gross Profit Margin?
Gross profit margin reflects the percentage of revenue that remains after deducting the cost of goods sold (COGS). Its a measure of profitability that indicates how effectively a business is managing its costs relative to its revenue.
The formula to calculate gross profit margin compares the gross profit to the total revenue, expressing it as a percentage.
Gross Profit Margin = (Gross Profit / Total Revenue) x 100%
Example:
For instance, in the example above, if a business earns $200,000 in revenue and incurs $120,000 in COGS, resulting in a gross profit of $80,000, the gross profit margin would be 40%.
Gross Profit Margin = ($80,000 / $200,000) x 100% = 40%
This means that for every dollar of revenue generated by the business, 40 cents are retained to cover other expenses and contribute to net income.
Higher gross profit margins suggest that a business can sell its products or services at prices higher than the cost of producing or acquiring them, indicating better profitability. Its an essential metric for assessing the financial health and efficiency of a business’s operations.
Gross Profit on the Balance Sheet
AASB 101 provides guidance on the presentation of financial statements, including the income statement where gross profit is typically reported.
This standard requires entities to present an income statement that displays expenses classified by their nature and to disclose additional information about the nature and amount of items included in each expense category.
By following the principles outlined in AASB 101, entities ensure that gross profit and other components of financial performance are accurately presented, providing stakeholders with a clear understanding of the business’s financial position and performance.
Importance of Gross Profit and Gross Profit Margin
Both gross profit and gross profit margin serve as valuable tools for evaluating a business profitability. However, while gross profit offers insights specific to the business at a particular moment, the gross profit margin provides a means to assess performance over time. Additionally, the gross profit margin facilitates benchmarking against competitors.
Typically, a higher gross profit margin indicates greater efficiency in generating revenue from a given inventory level. It directly reflects the effectiveness of a business processes and procedures.
Changes in the gross profit margin over time can signal market dynamics that the business needs to monitor closely. It may also reflect the effectiveness of the business’s pricing strategy. Thus, tracking the gross profit margin enables the business to adapt to market conditions and refine its pricing approach accordingly.
Comparison: Gross Profit vs Net Profit
Gross profit and net profit serve different purposes in evaluating a business financial performance. While gross profit focuses solely on the business ability to generate earnings relative to production and labour expenses, net profit provides a broader perspective by considering all costs and income.
Gross profit, which accounts only for direct costs, helps the business identify potential weaknesses in production processes or sales strategies. For instance, if the business finds that production costs exceed revenue, it may need to reconsider its operations to improve the gross profit margin.
In contrast, net profit offers a deeper understanding of the business financial status by including fixed costs and additional income not factored into gross profit calculations. This allows the business to identify fixed costs that may be negatively impacting profitability.
Even if gross profit appears satisfactory, other aspects of the business management, such as debt or loan management, could be problematic. Therefore, evaluating net profit is essential for gaining insights into overall business management effectiveness.
Comparison: Gross Profit vs Operating Profit
A business operating profit, also known as operating income, represents its earnings after deducting all production and operating expenses but before accounting for interest on debts, taxes, and non core income.
The formula for calculating operating profit involves subtracting the cost of goods sold (COGS), operating expenses (OPEX), depreciation, and amortisation from revenue.
The operating profit margin is calculated as:
(Operating Income / Revenue) * 100
This figure provides insights into the business profitability after considering all expenses related to revenue generating activities, excluding interest, taxes, and non core income.
Analysing both gross profit and gross profit margin alongside operating profit and operating profit margin offers a comprehensive view of the business financial performance.
While gross profit reflects earnings before operating expenses, operating profit shows profits after deducting all expenses related to revenue producing activities but before interest and taxes.
Operating profit and operating profit margin are particularly valuable as they account for sales and marketing costs, which are essential for the business’s success but not directly linked to the cost of producing goods or services.
Therefore, they provide a more accurate reflection of the actual costs associated with running the business’s business operations.
How to Improve Gross Profit
Improving gross profit involves various strategies aimed at increasing revenue or reducing the cost of goods sold (COGS).
Here are several actions a business can take to enhance its gross profit:
- Optimise pricing strategy: Adjusting product or service prices to ensure they adequately cover production costs while remaining competitive in the market can help improve gross profit margins.
- Streamline operations: Enhancing operational efficiency through process improvements, automation, and lean practises can reduce production costs and boost gross profit.
- Negotiate with suppliers: Negotiating better terms with suppliers, securing discounts for bulk purchases, or seeking alternative suppliers offering lower prices can help reduce the cost of raw materials and lower COGS.
- Reduce waste and inefficiencies: Implementing measures to minimise waste, optimise inventory management, and reduce production downtime can lower expenses and improve gross profit margins.
- Increase sales volume: Increasing sales volume through effective marketing, expanding distribution channels, or introducing new products or services can spread fixed costs over a larger revenue base, improving gross profit margins.
- Focus on high-margin products/services: Identifying and prioritising products or services with higher profit margins can contribute to overall gross profit improvement.
- Invest in technology: Investing in technology solutions such as inventory management systems, production automation, or data analytics tools can enhance operational efficiency and reduce costs, thereby improving gross profit.
- Train and develop employees: Providing training and development opportunities for employees to enhance their skills and productivity can lead to improved operational efficiency and higher gross profit margins.
- Review and optimise overhead expenses: Analysing and reducing overhead expenses such as rent, utilities, and administrative costs can free up resources to allocate towards revenue-generating activities, improving gross profit.
- Regular performance monitoring and analysis: Continuously monitoring key performance indicators related to gross profit, such as gross profit margin and COGS, and analysing trends can help identify areas for improvement and inform strategic decision making to enhance profitability.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.
