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 in the following formula:
Gross Profit = Sales Revenue – Cost of Sales
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 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.
Gross profit of a company is affected by many factors. A company can have a high or low gross profit for example 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 material 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.