Definition of Gross Profit
Gross profit is the profits after the deduction of the Cost of Good Sold from Revenues or Sales Revenues for a specific period of time.
It is the profit that the entity generates after deduction of the cost of goods or services only. Gross Profit is reported in the income statement of the entity and it is used to assess the profitability of the entity as well as cost control.
There are two important things that could affect the amount of Gross Profit of the same entity in the same period of time.
The first one is the revenue recognition policies. Different jurisdictions might use different accounting policies for revenue. For example, cash basis and accrual basis. If these two bases is used, the revenues will result differently.
Different Accounting policies that use to measure the ending value of inventories also affect the amount of cost of goods sold during the period.
For example, the value of inventories at the end of the period valued by FIFO might be different from the value that measures by weight average cost. As a result, the amount of cost of goods sold will be different and do so Gross Profit.
Here is the example of Gross Profit Formula:
Sales Revenue $XXXX
Cost of Goods Sold ($XXXX)
Gross Profit $XXXXX
Gross Profit Formula is Sales Revenue – Cost of Goods Sold
As you could see in the above example, to calculate Gross Profit you need to know Sales Revenues for the specific period and their Cost of Goods Sold.
Gross Profit Margin:
Gross Profit Margin is the proportion of Gross Profit over Sale Revenue for a specific period of time. The margin is normally shown in percentage when we perform calculations because it helps us to interpret easily.
Gross Profit Margin is very important as it is the indicator and measurement of how the entity controls its costs. If the margin is lower than the target or entity’s competitors, then it is said that the entity has poor cost control.
Subsequently, the entity might look at the design stage and figure out if there any opportunity that costs could be reduced while the quality still at the acceptable level.
Here is Gross Profit Margin Formula and how it is calculated,
The calculation of Gross Profit Margin equal Gross Profit / Sales Revenue
Let see the following example so that it could help you to figure out how the profit margin is.
Example: ABC is operating in retail products. For the period 01 January 2016 to 31 December 2016, ABC has the following transactions
Sales Revenue $50,000,000
Cost of Goods Sold $10,000,000
Calculate the Profit Margin of ABC for the period 01 January 2016 to 31 December 2016?
- Gross Profit = Sale Revenue – Cost of Goods Sold = $40,000,000 ($50,000,000 – $10,000,000)
- Gross Profit Margin = Gross Profit / Sales Revenue = $40,000,000 / $50,000,000 = 0.8 or 80%
As you can see, base on above calculation, ABC got 80% margin of its Sales. This margin is quite good yet, to make the better assessment, we need to compare this margin to our expectation or benchmark its again the competitors in the market.
After comparison, we could establish whether the current costing system is acceptable or not.
For example, if the margin is lower than its competitor, ABC might purchase the products at the high cost than its competitor; therefore, ABC needs to see if there are any others suppliers in the market that ABC need to approach or probably it needs to negotiate with the existing suppliers about the prices.
In this example, ABC is not the manufacturing company, but if it were, then ABC has to look into the costing system. Reviewing the costing system might be starting from the design stage until the final production process.
For the design stage, ABC might need to review if there is any component need to remove or redesign.
For the production stages, it needs to check if the production process is running correctly and efficiently. If not, the process monitoring or process redesign needs to be considered.
Gross Profit Ratio:
Profit Margin and Profit Ratio is the same thing. As we can see from the about example, Gross Profit Margin of Gross Profit Ratio of ABC at the period ended 01 January 2016 to 31 December 2016 is 0.8 or 80%.
Gross Profit VS Net Profit:
Well, I am not going to talk about what is different, but I am going to talk about why it is different and the main objective of these two profit calculations.
These two figures have their own objective and use for different assessment. For Gross Profit Margin, we use it to assess the direct cost of products.
The cost could be the cost of purchasing the final product for reselling or the cost of production. Including direct labor, direct overhead, and direct material.
If the margin is lower than expected or competitors, actions should be taken. If the margin is higher than competitors or expectations, that means the production system is good and the company needs to maintain it.
In order words, the company has competitive advantages over its competitors.
Net Profit Margin, on the other hand, does not use to assess the production cost of the company, yet its use to assess the operating expenses in the company.
Those operating expenses include transportation, commission, sale and marketing expenses, and other operating expenses that not related to the production cost.
These expenses need to carefully control and review by management of the company. If the Net margin is low, that means the operating expense might be overspend. Then, the line by line analysis and review needs to be taken.