Businesses must generate profits to stay afloat. They do this by producing goods or services and selling them for more than it costs to produce them. This difference is the gross margin of the business: turnover minus the cost of producing the goods or services sold. If the number is positive, it means the business is selling effectively; if it is negative, it means the company is losing money.
Gross profit is a powerful indicator of the production efficiency of a company. How well does the business use labor and supplies to produce salable goods at a profit? This is something that investors will look at when they assess the strength of a company and its prospects as an investment.
Here’s why it’s important and what it means to calculate and understand it as a basic financial valuation metric.
How to calculate gross profit
The gross margin also passes profit from sales Where gross revenue, and the names are relatively interchangeable. Either way, they are all calculated in exactly the same way. The formula is relatively simple, specifically focused on the difference between COGS and income:
Gross profit = Revenue – Cost of goods sold
Companies use this equation as a yardstick to compare company performance. For example, it can compare the gross profit of the current quarter to the last quarter, or to the quarter of the previous year. Calculating over time allows companies to see increases and decreases in efficiency and identify the catalysts behind them. A company can also compare its gross profits to that of a competitor, to see how it is doing.
XYZ Company generated revenues of $ 1 million during the year. The COGS represent $ 800,000. The gross profit of the business for the year is $ 200,000. That said, it’s important to remember that this number does not represent fixed costs, such as the rent that the business pays for its building. Its net result should therefore be lower.
Companies will also use it to calculate gross margin, represented as a percentage of revenue. In the example above, the gross margin of the business is 20%: a profit of $ 200,000 on $ 1 million in revenue. Companies frequently report gross margin and gross profit together, juxtaposed.
What factors in gross profit?
The main factors that contribute to the gross profit of a business are variable expenses. They rise and fall frequently, resulting in variability in COGS. Companies that are able to reduce or control variable costs tend to have higher gross margins and, in turn, higher gross profits. A business may see higher or lower gross profit over a period due to changes in any of the following costs:
- Labor costs
- Sales commissions
- Processing fee
- Equipment costs
Gross profit does not include fixed costs. This includes rent, fixed wages, insurance and the like, which are operating expenses. That said, these costs end up factor in the fixed cost of each good sold through absorption accounting in accordance with generally accepted accounting principles (GAAP).
The price is also taken into account. The higher the price of a unit, the more accommodation there is for variable costs. If it costs $ 10 to produce a widget and the company sells it for $ 20, its gross margin is $ 10. If the company sold it for $ 50, it would still cost $ 10 to produce, but the gross profit would be $ 40.
Comparison of net income
Gross profit is often confused with net profit; However, the two are different. This is the amount of income remaining after subtracting the COGS. Net income is the profit of a business after subtracting all expenses from income. It provides a more complete picture of the company’s free cash flow. Higher net income numbers represent a strong and healthy business, especially when sustained over time. Gross profits are often a big contributor to net income, but the two are not the same thing.
When looking at the two measures together, it is best to consider what proportion of net income is attributable to it. Strong gross profits often contribute to a sustainable income, which fuels the business as it grows.
Comparison of operating profits
Gross margin and operating margin are not the same. Operating profit, also known as earnings before interest and taxes (EBIT), is the profitability of a business before interest and taxes. Gross profit is simply the profit generated from the sale of goods or services, less COGS. The operating result is much more global since it takes into account all business income and expenses.
While both are important financial metrics when it comes to valuing a business, gross margin provides a much more focused snapshot of core business sales. For example, strong investment performance and poor sales can give a business huge operating profits. This takes into account how investors assess a business over the long term, including its ability to sustain operations through strong sales.
Is the business profitable?
When it comes to financial reporting, many different indicators can signal How? ‘Or’ What a business generates profits. Foremost among them is its gross margin: the gains attributable to its ability to efficiently produce and sell products or services. Companies with high gross profits demonstrate a healthy sales pipeline, and positive free cash flow tends to follow. This leads to reinvestment in the business, which leads to new growth and a new scale which brings even more profitability. As an investor, it’s important to fully understand this data and make better decisions for your portfolio. Therefore, register for the Profit trends e-letter below and learn tips and trends from some of Wall Street’s top experts.