Businesses use gross profit to assess financial health by calculating the money left over from sales after subtracting the cost of goods sold. This figure is used to determine production efficiency and can be increased by raising prices or decreasing costs. However, it does not necessarily equate to higher profits, and a steady decline may indicate the need for changes in the company. Gross profit is a required income statement item in the US.
Business owners and managers involved in the financial management of a company use a variety of numbers and ratios to assess that company’s financial position. Gross profit is a term to describe the money left over from the sale of products after subtracting the cost of goods sold without taking out the money needed to pay operating expenses. Knowing how much of each sale is left to pay salaries and other fixed expenses helps leaders determine the financial health and viability of the operation.
To calculate gross profit, you must first understand what comprises cost of goods sold. Not all expenses a business incurs qualify for this figure. Only costs directly related to the production of the product are used. As a general rule, if the cost in question varies in relation to the number of products produced, it is a variable cost and therefore appropriate for inclusion in cost of goods sold.
Production efficiency is determined using this measurement as a base. Gross profit margin, ratio, and percentage represent the same calculation. These calculations are reached by dividing gross profit by total revenue. For example, if the gross profit is $1,000 US Dollars (USD) and the total revenue is $2,000 USD, the gross profit margin is 50 or 50%.
Business executives use this margin to assess the efficiency of the company as a whole and, in some cases, individual business units or products. Since only two variables play a role in this figure, there are only two ways to influence it. An increase in price or a decrease in costs increases gross profit, while a decrease in price or an increase in costs will decrease it.
When tracked over time, increases in gross profit indicate that the company is more efficient at making money based on products sold. However, this does not necessarily equate to higher profits for the company, because factors such as employee wages, taxes, and rent can increase to reduce net profit. On the other hand, if the trend is a steady decline in gross profit, company officials may find it necessary to discontinue a product or revamp the way they run the company. Gross profit is a required income statement item in the United States, and must have a separate line item to comply with Generally Accepted Accounting Principles (GAAP) rules and standards.
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