Gross profit: Why is it important?

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Every small and large business provides goods and services to the public for the purpose of making a profit. How good or bad the profit-making capability of a company determines its success and survival.

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Answer Adeosun
Sep 20, 22 · min read
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In this article, we will be taking a brief but concise look into what gross profit or gross income means to businesses, its importance, and its uses. It is our hope that by the time you are done reading this article, you have a better understanding of gross profit and its intricacies.

Definition of gross profit

Gross profit is the difference between the total cost of production and the total revenue from sales made by a company or business.

Simply put, the gross profit or gross income of a company is the amount left after the total cost implication of producing goods or services is subtracted from money made from sales or revenue generated. 

Gross profit can also be called sales profit.

The gross profit of a company generally measures and indicates the efficiency of the company in effectively producing and supplying its goods or services to customers.

How to calculate gross profit?

Gross income or profit can be calculated using the formula: 

Gross profit = Total revenue – Total cost of production.

The total revenue is the amount of the net sales from goods and services. The net sales however are the sales revenue excluding the cost of discounts and damaged or returned goods. In other words, the total revenue of a company has to take into account the discounts given and the cost of damaged goods. 

Thus, while the total sales should tell the financial health of a company, the net sales tell it better. This is because if the cost of damaged and returned goods is high, the net sales then reduce grossly.

The cost of production or cost of goods sold (COGS) on the other hand takes into account the cost of raw materials and labour costs. This does not include fixed costs such as buildings, machinery, or office supplies. These do not change no matter the level of production. However, an assigned cost can be included for the fixed costs under absorption costing. Absorption costing allows the company or business to distribute the total fixed costs on all goods produced in a given period. For example, if:

  1. The cost of a building lease, machinery maintenance, and office supply was $20,000 for three months, and
  2. The company produces 50,000 goods in that period.

The company is allowed by the GAAP (generally accepted accounting principles) to include an absorption costing of $0.40 for every one of the goods it sells in that period. This takes care of fixed costs.

Importance of gross profit to businesses

As mentioned earlier, the gross profit of a company shows how efficiently the company uses the resources it has to produce goods and services. When there is high efficiency, the gross profit or income will be high.

What are the differences between gross profit and net income?

The main difference in the net income of a company is in their calculations and uses.

-→ Differences based on the calculation

The gross profit is the difference between total revenue from sales and the cost of goods sold. Net income on the other hand subtracts all COGS, taxes, operation expenses, depreciations, interests, amortizations, etc. from total revenue. 

By this, we can see that net income will vary widely from gross profit.

-→ Differences based on uses

The net income shows how much of liabilities the company is willing to take on to produce its goods and services. This is because the net income takes into account all the expenses a company makes for a period, including loans. 

Investors who consider only the gross profit of a company to judge the health of the company have only done half of their due diligence. The net income is the real measurement of the management efficiency of the company.

What are the advantages of using the gross profit?

The following are the advantages of why companies calculate their gross profits.

  1. The gross profit shows the customer satisfaction levels for the goods and or services produced by the company. It shows how much people are willing to pay for the goods the company produces.
  2. The items that factor into the calculation of gross profit can easily be handled and managed unlike that of net profit. No company can single-handedly modify inflation or deflation, but a company can find ways to reduce its cost of production and thereby increase its gross profit.

What are the limitations of using gross profit?

Limitations of gross profit are listed below
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1. Cannot adequately measure the company's overall performance.

Since the gross profit only takes the cost of goods sold into consideration, it presents as though the only way the company can increase its gross profit is by raising the unit price. However, it could be that they needed advanced production technology, more experienced staff, or even management restructuring.

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