What is Gross Profit?
Gross profit is the profit a business makes from revenue generated by selling a product or a service and deducting the cost of goods sold or operating expenses.
When calculating the gross profit, it’s important to understand the difference between variable and fixed costs. Variable costs change based on the number of products or services produced. In other words, these are costs directly attributable to producing a product or a service. Examples of variable costs are direct labor, materials, depreciation and production.
Fixed costs are static, meaning that a business will incur those expenses regardless of how many products or services it produces. Examples of fixed costs are rent, administration costs and other expenses not directly dependent on sales.
Key Learning Points
- Gross profit is the earnings generated by a company after deducting all costs directly associated with the production of the product or service sold.
- The costs which are deducted from revenue to calculate gross profit are most commonly known as either ‘cost of goods sold’ or ‘direct costs’.
- Variable costs are those which are dependent on production levels.
- Direct costs (or fixed costs) are costs that a company incurs regardless of how many products it produces.
- Gross margin measures how effective a company is at turning its revenues into gross profits. It presents gross profit as a percentage of revenue.
Gross Profit Formula
Gross profit is the profit of a manufacturing or a direct service. There are two ways to calculate the figure:
Sales – Cost of Goods Sold
Sales – Direct Costs
It’s not only manufacturing companies that report a Cost of Goods Sold, such as the example of Coca Cola and Pepsi under key ratio below. Service providers have direct costs or operating expenses, which are used to calculate their gross profit.
Below is an income statement extract from a company that provides a service:
Extract from the Consolidated Income Statements for the Year ended August 31, 2019
- Accenture provides a service so the company reports operating expenses, and not cost of goods sold like manufacturing companies.
- Accenture contracts consultants who provide a service to generate revenue, so the company reports those costs under ‘Cost of services’.
- Accenture’s consultants incur marketing and administrative costs in order to provide a service, which is reported under ‘Sales and marketing’ and ‘General and administrative costs’.
- Accenture’s gross profit is revenue minus its cost of services.
- Gross Margin – Shows the profits of production driven by price advantages and cost advantages and measures how effectively a company turns its revenue into profit. To calculate the ratio, divide gross profit by the revenue. It’s expressed as a percentage.
Below are extracts from the financial statements of Coca Cola and Pepsi:
The Coca-Cola Company – Extract from 10-Q September 2019 form
PepsiCo, Inc and Subsidiaries – Extract from 10-Q July 2019 form
Points to Note
- Numbers are in millions.
- Coca Cola’s gross margin is 60% (5,740/9,507) x 100.
- Pepsi’s gross margin is 55% (9,494/17,188) x 100.
- The comparison shows that Coca Cola’s GP margin is higher, despite Pepsi generating more revenue, meaning Coca Cola is better at managing the production costs or has better pricing power (they also have slightly different business mixes).
How Companies Improve Their Gross Margin
Two methods are available to companies for improving their gross margins. The first is to increase the price of their products or services, and the other is to lower their costs to produce goods or services.
A company can increase the price it can charge for its product by creating competitive advantages such as patents, or improving its brand recognition.
A company can decrease the cost of its production by using economies of scale or better production management.