Gross profit is net sales 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. Gross profit is typically stated partway down the income statement, prior to a listing of selling, general, and administrative expenses. The gross profit formula is:
Revenue - (Direct materials + Direct labor + Factory overhead)
How to Calculate Gross Profit
The calculation of gross profit is a multi-step process, as outlined below:
- Aggregate gross sales information and all deductions from sales to arrive at net sales. The deductions from sales should include sales discounts and allowances.
- Aggregate direct cost of goods sold information. Be consistent in drawing this information from the same expense accounts from period to period, in order to report a consistent gross profit figure.
- Shift factory overhead costs into one or more cost pools.
- Collect allocation information for the period. Again, be careful to use the same basis of information from period to period, to create consistent results.
- Allocate the factory overhead cost pool(s) to cost objects (i.e., produced goods).
- Charge sold units to the cost of goods sold.
- Subtract the direct cost of goods sold and the factory overhead charged to the cost of goods sold from net sales. The result is the gross profit for the period.
Gross Profit 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 profit is $330,000.
Gross Profit Analysis
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
Gross profit is also known as gross margin and gross income.