Most companies measure their success by looking at various financial figures, and one key figure is gross profit. Gross profit shows how much money a company makes from its core business activities after subtracting the cost of producing its goods or services. It’s a basic way to see if a company is making enough to cover its production costs and still have some left over. Keep reading to learn more.
What is gross profit?
Gross profit is the money a company makes from selling its products or services after covering the direct costs of making them. It’s a key measure of how well a company is doing in its core business activities. To find a gross profit, you subtract the cost of goods sold (COGS) from total sales revenue.
Example of gross profit
Let’s use Microsoft (MSFT.US) as an example to explain gross profit.
Suppose Microsoft earns $60 billion in revenue from selling its software and services. The costs directly related to producing and delivering these products, such as development and support costs, total $20 billion.
Formula:
Gross profit = Total revenue − Cost of goods sold (COGS)
Calculation:
Gross Profit = $60 billion − $20 billion
Result:
Gross Profit = $40 billion
Explanation:
Microsoft’s gross profit of $40 billion is calculated by subtracting the cost to produce and deliver its products ($20 billion) from its total revenue ($60 billion). This gross profit shows the money Microsoft makes from its core business activities before other expenses are considered.
Advantages & limitations of using gross profit
| Advantages | Limitations |
|---|---|
| Insight into core operations: Gross profit highlights how well a company performs in its core business activities, excluding other expenses like marketing and administrative costs. This focus helps in understanding the profitability of a company’s primary operations. | Does not reflect all costs: Gross profit doesn’t account for operating expenses, interest, taxes, and other non-operational costs. This means it doesn’t provide a complete picture of a company’s financial health. |
| Comparison across periods: It allows for easy comparison of a company's performance over different periods. A rising gross profit suggests improved efficiency or higher sales, while a falling gross profit may indicate rising costs or declining sales. | Lacks insight into profitability: Since it excludes overhead costs and other expenses, gross profit alone doesn’t show the true profitability of a company or its net income. |
| Benchmarking: Investors and analysts use gross profit to compare companies within the same industry. It provides a baseline for assessing operational efficiency and profitability against peers. | Can be misleading: Companies with different business models or cost structures might have similar gross profits but vastly different net profits. This can mislead investors if gross profit is used in isolation. |
| Pricing and cost management: Understanding gross profit helps businesses evaluate their pricing strategies and manage production costs effectively to maintain or improve profitability. | Ignores revenue quality: Gross profit doesn’t consider the quality or sustainability of revenue. A company could have high gross profit but be struggling with high operational costs or other financial issues. |
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Summary
As you've learned, gross profit is a key measure of a company’s ability to generate profit from its core operations by subtracting the cost of goods sold from revenue. It provides valuable insights into how efficiently a company produces and sells its products. However, it doesn't account for other operating expenses, interest, taxes, or non-operational costs, so it's important to consider gross profit alongside other financial metrics for a complete picture of a company’s overall financial health and profitability.
Source: investopedia.com
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