Gross Profit (Gross Margin)
Gross profit (gross margin) is the sales revenue less the cost of sales (or cost of goods sold). It is also known as “gross margin” or “gross income”. Gross profit can be expressed using the following formula:
Gross profit of an entity is its residual profit after selling a product or service and subtracting the costs associated with its production and sale. The associated costs can include manufacturing costs, raw material expense, direct labor charges, and other directly attributable costs.
Gross profit calculation under IFRS and US GAAP
The calculation of gross profit may differ slightly between International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) due to differences in the names of income statement line items.
In accordance with IFRS, gross profit is calculated as:
Gross Profit = Total Revenue - Cost of Goods Sold (COGS)
IFRS defines COGS as the cost of acquiring or producing goods that are sold. This includes direct costs such as materials, labor, and overhead costs associated with production, as well as indirect costs such as depreciation and amortization related to production.
In accordance with US GAAP, gross profit is calculated as:
Gross Profit = Net Sales - Cost of Goods Sold (COGS)
US GAAP defines COGS as the cost of goods sold during a specific period, including the cost of raw materials, direct labor, and overhead costs related to production.
Gross profit is very important measure to consider when analyzing the profitability and financial performance of a company. Gross profit is an important measure because it indicates the efficiency of the management in using labor and supplies in the production process.
Factors Affecting Gross Profit
A company's gross profit is affected by many factors. For example, a company may have a high or low gross profit because:
- It has differentiated its products and therefore can charge high prices
- It is being managed efficiently therefore it has low cost of sales
- Its accounting policies move expenses from cost of sales to overheads (or vice versa)
- It is vertically integrated and can purchase raw materials at lower costs
It should be kept in mind that gross profit usually varies significantly from industry to industry. Therefore while appraising the performance of a company, the comparison should be made with the companies in the same industry.
Changes and trends in gross profit margin can often provide useful information for the investors. Therefore, the gross profit of a company should be analyzed over a number of periods.
Although gross profit provides the important information about how much mark up a company can make on its sales, it is not the best measure of profitability of a company as a whole because it excludes many costs such as financing costs and overhead expenses. Therefore profitability of a company should not be measured solely on the basis of gross profit.
Gross profit and Balance Sheet
Gross profit can have an impact on a company's balance sheet in several ways:
- Inventory Value: If a company's gross profit decreases, it could indicate that the company's costs of goods sold have increased. This, in turn, could result in a higher value for the company's inventory on its balance sheet, as the cost of the goods being held in inventory would also be higher.
- Accounts Receivable: If the company's sales decline, it could also result in a lower balance for accounts receivable on the balance sheet, as customers may take longer to pay their bills.
- Retained Earnings: If the company's gross profit decreases, it could impact the company's retained earnings, which is the portion of net income that is not paid out as dividends to shareholders but instead is reinvested in the business. Decreased retained earnings could limit the company's ability to invest in growth initiatives.
- Debt: If the company's financial performance is impacted by declining gross profit, it could make it more difficult for the company to pay its debts and maintain a positive cash flow, potentially resulting in increased debt on the balance sheet.
Declining Gross Profit: Management Decisions
A company's dropping gross profit is a sign that either its costs are increasing, its sales are declining, or a combination of the two. To solve this problem, management should take the following actions:
- Analyze the Cost of Goods Sold (COGS): Management has to thoroughly examine the COGS to find any areas where expenses have gone up. This might apply to the price of raw materials, direct labor, overhead, or any other production-related expenses.
- Review Sales Trends: To ascertain whether there has been a drop in revenue, management should also examine sales trends. This could be brought on by a decline in the demand for the company's goods, rising competition, or other market circumstances.
- Identify and Address inefficiencies: Management should identify and address any inefficiencies in the company's operations that may be contributing to the increase in costs. This may include reviewing processes and procedures, reducing waste, and improving production efficiency.
- Consider Price Increases: If there is no immediate way to lower the company's rising costs, management may think about boosting prices in order to retain profitability.
- Explore New Markets or Product Lines: If the company's sales are declining, management may consider exploring new markets or product lines to increase revenue and restore profitability.
- Assess Capital Expenditures: Management must carefully assess any capital expenditures, such as investments in new machinery or technology, to make sure they are essential and will ultimately boost the company's financial performance.
When a company's gross profit is declining, it is crucial for management to closely examine and assess the business's operations and financial performance to identify the root of the problem and take the necessary steps to get the company back on track.