Understanding Gross Profit

Gross profit is defined as Sales – COGS with COGS standing for Cost of Goods Sold. The formula is simple enough, but really understanding gross profit involves more than just knowing how to calculate it.

Gross Profit Margin

This calculation for gross profit margin is (Sales – COGS) / Sales and is expressed as a percentage. This formula, like the one for gross profit, is very straight forward. However, the gross profit margin does tell us some things that the gross profit itself does not. Let’s look at an example. In the example we will look at two different months for the same manufacturing company. We will also assume that the company has no ending inventory at month end for both months.

gross profit calculation

Some Analysis

When you look at this example, at first nothing seems to be all that significant. Sales in month 2 were less so you naturally expect your gross profit to be less. But look at the gross profit margin. For the first month it is 40% but in month two it drops to 33%., a decrease of 7%. That is significant. Now see the analysis of cost of goods sold. As you can see the variable cost as a percentage of sales is the same for each month but less in dollar amount for month two. However, the fixed cost remains the same in dollars but jumps 7% as a percentage of sales. Since there was no ending inventory, all of the fixed costs of manufacturing had to be absorbed both months.

This analysis demonstrates the significance of the amount of sales on the gross profit and the gross profit margin percentage. A key to understanding gross margin is to understand that the level of sales and your ability to control fixed costs can have a dramatic impact on your profitability. We are starting to get into break-even analysis here, but I will leave details of that for another article.

Do you understand gross profit and gross profit margin? Understanding this is critical to making sense of you income statement. Even more important is know what you can do to help improve both of these key measures.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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