What is gross profit?

Gross profit is revenues minus the cost of goods sold. It reveals the amount that a business earns from the sale of its goods and services before the application of additional selling and administrative expenses.

The gross profit formula is:

Revenue - (Direct materials + Direct labor + Factory overhead)

For example, ABC International has revenues of $1,000,000, direct materials expense of $320,000, direct labor expense of $100,000, and factory overhead of $250,000. Therefore, its gross margin is $330,000.

From an analysis perspective, gross profit can be a flawed calculation, depending on the level at which it is used. For example:

• Product level. Overhead should not be applied at the individual product level, so contribution margin (which excludes overhead) is a better analysis tool. Another option is to use just throughput, which is essentially revenue minus direct materials expense.
• Product line level. Some overhead related to a product line can be applied at this level, so a portion of factory overhead can be included in the calculation.
• Business unit level. Probably all of the factory overhead costs listed in the gross profit on a company's financial statements can be included in this calculation.

Thus, the gross profit calculation is less relevant at the unit level, and more relevant at the business unit level.

Gross profit is more useful when tracked as a percentage of sales on a trend line. You can then drill down on those periods where the percentage is lower than average to see what caused the reduction. Examples of reasons for a gross profit change are:

• The presence or absence of sales allowances
• A change in the mix of products sold
• Changes in product prices
• Differences in the material content of different products
• Differences in the amount of labor needed to manufacture different products
• Changes in the purchased cost of materials
• Changes in the cost of labor per hour
• Changes in the amount of overtime paid
• Changes in the cost of overhead
• Changes in the method used to allocate overhead
• Changes in the amount of outsourced manufacturing used

Similar Terms

Gross profit is also known as gross margin and gross income.

Related Topics

Financial statement analysis 
Horizontal analysis 
How to calculate contribution per unit 
Vertical analysis 
What is gross profit analysis?