Gross Profit Definition
Define Gross Profit In Simple Terms
Gross Profit is a “Profitability Ratio” used by investors, analysts, and company management to show how efficiently a company produces an item.
It monitors the manufacturing process by subtracting the cost of production, also known as Cost of Goods Sold, from revenue.
A higher gross profit indicates that the company is becoming more efficient in producing the product or is selling products for higher prices.
Gross Profit Formula
The Gross Profit Formula is:
- Gross Profit = Revenue – Cost of Goods Sold
Cost of Goods Sold is an accounting term that includes all costs of acquiring, manufacturing or otherwise producing an item.
This includes raw materials, labor, manufacturing overhead and shipping costs; every cost up until the product is ready for sale.
Gross Profit has limited value though because the resulting amount is not scaled to be easily compared to other products or companies.
A computer will have a higher Gross Profit than a calculator, even if the calculator is produced more efficiently, because it is sold at a higher price.
Gross Profit vs Gross Profit Margin
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Instead, Gross Profit Margin is more often used.
It takes gross profit and divides it by revenue to return the percentage of gross profit for each dollar of revenue. This scaling makes comparisons easier.
- [Gross Profit Margin = (Revenue – COGS) / Revenue]
Gross Profit Margin can be used to compare products, companies, or even entire industries.
Companies with a higher Gross Profit Margin will be more attractive to investors because they are better at the core operations of the business, producing a product.
Demonstrating this, many popular management philosophies such as Just-In-time Manufacturing, Total Quality Management and Six-Sigma all rely on Gross Profit Margin as a way to show their success.