Income Statement of a company is one of the richest sources of information concerning its financial health and standing. There are numerous measures in an Income Statement that facilitate one’s understanding of the factors as mentioned earlier. One of these measures is the gross profit of an organisation.
What is Gross Profit?
Gross profit is the measure of a company’s profits directly stemming from its sales after accounting for the Cost of Goods Sold or COGS.
In other words, it is the excess of revenues in an accounting period over the costs directly related to providing services or production of goods. Such costs can be broadly bifurcated into manufacturing expenses and labour costs.
It is a key measure for both concerned companies and outsiders like shareholders, investors, etc.
Gross profit provides an understanding of a company’s management soundness. It also helps to gauge the amount it can retain from sales to mitigate other operational expenses, liabilities, distribute dividends, and keep in reserves.
Furthermore only manufacturing expenses and labour costs are excluded from total revenue generated in an accounting period. It, thus, portrays a company’s managerial efficiency in utilising such resources to produce goods and render services.
How to Calculate Gross Profit?
It involves deducting the cost of goods sold from net sales or total revenue. Thereby, to calculate gross profit, one must first calculate the two components – COGS and net sales.
1. Calculation of COGS
As mentioned before, the cost of goods sold includes the expenses that are directly related to production. In other words, COGS includes the variable costs. This category of cost incorporates –
- Raw materials
- Direct labour
- Freight or shipping charges
There might be other expenses as well that go into producing goods and providing services.
Generally, fixed costs are not included in the calculation of gross profit. These are costs that do not fluctuate with changes in production scale, such as the salary of employees, office rent, etc. However, under absorption costing a portion of such fixed costs are incorporated on a per-unit basis. According to GAAP, absorption costing is necessary for external reporting of a company’s finances.
Nevertheless, as per accounting practices, COGS = [Inventory (opening balance) + Purchases] – Inventory (closing balance)
Example: Company KLM purchased Rs.50000 worth of inventory in the fiscal year 2019 – 20. The opening inventory value on 1st April 2020 was Rs.2 lakh. The closing inventory value on 31st March 2020 was Rs.2.25 lakh. Therefore, COGS = Rs. [(200000 + 50000) – 225000] = Rs.25000.
2. Calculation of net sales
Net sales involve the total amount of gross sales – both in cash and credit – in a particular year minus the sales returns, allowances, and discounts.
Thence, Net Sales = Gross Sales – (Returns + Discounts + Allowances)
Example: Company KLM recorded sales worth Rs.1.5 lakh in the fiscal year 2019 – 20. Out of that, goods worth Rs.25000 were returned due to spoilage. It also allowed a discount of Rs.5000 against a sale of Rs.50000. Ergo, its net sales = Rs.150000 – (25000 + 5000) = Rs.120000.
In case there are no adjustments against the gross sales amount, it is considered as net sales.
3. Calculation of gross profit
Finally, after the calculation of both COGS and net sales, GP can be computed using the gross profit formula, i.e.
Gross Profit = Net sales – Cost of Goods Sold
Example: Let’s consider an excerpt from Hindustan Unilever’s Profit & Loss Statement for FY 2018 – 19, as mentioned below.
|Particulars||Amount (in Rs. crores)|
|Revenue from operations||38,224|
|Materials consumption cost||13,240|
|Finished goods inventory changes (inclusive of stock-in-trade) & work-in-progress||12|
|Purchases of stock-in-trade||4,708|
|Employee benefit expenses||1,747|
|Depreciation and Amortisation expenses||524|
Here the expenses that come under the ambit of COGS are the cost of materials consumed, changes in inventory, and purchases of stock-in-trade because they are directly related to revenue generation.
Ergo, Cost of Goods Sold = Rs. (13,240 + 12 + 4708) crore = Rs. 17,960 crore.
The total income is synonymous to net sales in this gross profit equation, since there are no recorded returns or discounts allowed.
Hence, Gross Profit = Rs. (38,888 – 17,960) crore = Rs. 20,928 crore
Why Is Gross Profit an Important Measure?
As mentioned previously, the gross profit of a company is a critical measure of its financial standing and management efficiency. Therefore, the two most crucial inferences that can be drawn from the gross profit are –
- The value of resources a company is utilising behind the production.
- The scale of revenue it can generate against such resources.
Limitations of Gross Profit
One major drawback of using gross profit as a metric for gauging a company’s financial footing is that it does not reveal much in itself. Simply learning about the gross profit of a company cannot facilitate an analytical understanding of a company’s core business efficiency.
- Does not facilitate relative comparison between companies
Companies that have large-scale production and sales will indefinitely boast of substantial gross profits compared to a company with small-scale counterparts. However, that does not reveal anything about the efficiency but only, the scale of business operations.
Such analysis cannot be the foundation of comparison between companies with different market capitalisations.
Assume, there are two companies – Company A and Company B. The former recorded a gross profit of Rs.6 lakh while the latter recorded a gross profit of Rs.2 lakh for FY 19 – 20. Company A’s sales for that period is Rs.12 lakh, whereas Company B’s sales figure is Rs.3 lakh.
Here, although Company A recorded higher sales, it also recorded higher COGS, i.e. Rs.6 lakh (1200000 – 600000). However, Company B only recorded COGS worth Rs.1 lakh (300000 – 200000).
Therefore, it can be concluded that Company B’s management is more efficient in handling costs than Company A.
- Comparative gross profit is not an indicator of financial health
The understanding of a company’s financial health over time is not adequately supplemented by comparative gross profits. A lower gross profit of a company compared to its preceding year does not necessarily mean its financial health is degrading. Neither does it imply poor management.
Conversely, a higher gross profit compared to a previous year does not necessarily mean such a company’s financial health has improved. It also does not indicate efficient management. For proper understanding, gross profit shall be contextualised against contributing factors that can impact the figures but does not necessarily imply internal shortcomings.
Furthermore, the implication of gross profit is only limited to a company’s profits and not its profitability. The latter is more critical in understanding a company’s financial health, standing and management competency.
Gross Profit vs Gross Margin
Gross margin, also known as gross profit ratio, is the ratio between a company’s gross profit and total revenue. As opposed to gross profit, gross margin betrays the profitability of a company.
Therefore, it is a more reliable metric for gauging a company’s financial health and also its ability to manage cost in relation to total revenue effectively. Furthermore, it is also a critical measure of comparison between companies with different market capitalisations.
Gross margin is calculated using the following formula –
Gross margin = Gross profit / Total revenue
The difference between gross profit and gross margin can be further understood with the help of examples.
Gross Profit example: In FY 19 – 20, Company A recorded sales worth Rs.25 lakh and incurred production expenses of Rs.15 lakh. Therefore, its Gross Profit = Rs. (2500000 – 1500000) = Rs.10 lakh.
Gross margin example: Let’s consider the above instance of Company A. According to the gross profit calculator, its GP came about to be Rs.10 lakh. Ergo, its Gross Margin = (1000000 / 2500000) = 0.4 or 40%
Gross Profit vs Net Profit
Calculation of net profit involves the deduction of all costs indirectly related to production and revenue generation such as administrative expenses, taxes, etc. It provides a more detailed understanding of a company’s profits since all expenses are accounted for in this case.
Therefore, net profits are a direct representation of how much a company is retaining for mitigating liabilities, distributing dividends, and retaining for future contingencies.
- What is a good gross profit ratio?
There is no singular ratio that can be cited as good across industries and companies with different market capitalisations.
- Where to find gross profit in the Income Statement?
It is mentioned as a separate line with a proper breakdown in the Income Statement, according to GAAP guidelines.
- Is advertisement expense deducted from sales when calculating gross profit?
No, advertisement is an indirect expense and does not fluctuate with production volume. So, it is not included in the cost of goods sold.