Gross Profit on the Income Statement

Investing Lesson 4 - Analyzing an Income Statement

Gross Profit on the Income Statement
Gross profit is calculated from the income statement by taking total revenue and subtracting cost of goods sold. It is important because it allows you to calculate the gross profit margin, which can tell you a lot about the nature of a business. Pali Rao / E+ / Getty Images

If your here to learn about what gross profit is and why it is on the income statement, you've come to the right place. In the next few minutes, I'll explain what it is, how it is calculated, what it can tell you about a business, and why it is so important.

What Is Gross Profit?

The gross profit a business earns is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold.

It tells you how much money a company would have made if it didn’t pay any other expenses such as salary, income taxes, copy paper, electricity, water, rent, postage, furniture, software, or holiday parties for the employees.

Where Can I Find Gross Profit on the Income Statement?

When you look at an income statement, instead of searching for a needle in a haystack, GAAP rules requires gross profit to be broken out and clearly labeled as its own line so you can't miss it.

How Can I Calculate Gross Profit?

The formula for calculating gross profit is incredibly simple. You simply have to subtract cost of the goods sold from revenue. That is:

Gross Profit = Total Revenue - Cost of Goods Sold (COGS)

Imagine that you own a small business structured as a limited liability company. You sell luxury shaving sets. After researching various vendors, you finally find a reputable source and import a British luxury shaving set for $160.

You pay $20 for various merchant fees, bank processing costs, and other expenses directly related to the cost of goods. You pay $20 in incoming freight charges to receive the shaving set at the store. After creating a beautiful display for the new product and opening your doors for business the next day, a customer comes in and buys the shaving set for $315.

 What is your gross profit?

To answer this question, all you have to do is quickly construct an income statement in your head. You know that you collected $315 for the sale. You know that the cost of goods sold is $200 ($160 in merchandise cost + $20 in merchant, bank, and other cost of goods sold expenses + $20 in incoming freight expense). Now, all you have to do is take $315 and subtract $200 to arrive at $115, which is your gross profit.

Here is one of the interesting things about being a business owner. Imagine, for a moment, that you run a 20% off sale. This drops the retail price of the luxury shaving set from $315 to $252. Your costs remain the same at $200. This means your gross profit is $52. (The math: $252 in sales revenue - $200 in cost of goods sold = $52 gross profit) This means the 20% discount you gave wiped an incredible 54.8% off your gross profit. It doesn't make a lot of sense to discount unless you think that the lower sales price will drive up the asset turnover ratio as part of a DuPont return on equity strategy. Otherwise, you're severely cutting into your owner earnings.

What is the Importance of Gross Profit?

The gross profit figure is a big deal because it is used to calculate something called gross margin, which we will discuss on the next page of this lesson.

In fact, you can't really look at gross profit on its own and know if it is "good" or "bad", making the gross margin even that much more important as that is where the real story resides.

What Are Some of the Limitations of Gross Profit?

Accounting rules give management a lot of discretion. Among the bigger problems as it pertains to the gross profit calculation is that executives have some leeway when determining whether an expense should be included in cost of goods sold or another section, which we will discuss later, called selling, general, and administrative expenses.

This means that you could be looking at two companies operating in the same sector or industry and they could appear to have very different gross profit levels on the same amount of sales when, in reality, it is nothing more than one management team deciding that a certain expense is a cost of goods sold and another deciding that the same expense is part of selling, general, and administrative expenses.

There is not necessarily anything nefarious going on when this happens - reasonable people can and do disagree about where certain items should go on an income statement - but it creates a bit of a problem in that you could quite literally be looking at two identical companies with one reporting much higher gross profit than another for the same level of revenue. In a case like this, though, the net profit margin would remain the same so it wouldn't have an influence on basic or diluted earnings per share. But now I'm getting ahead of myself. The key thing is to remind you that you cannot do an apples-to-apples comparison of most businesses without making some manual adjustments to the financial statements.

More About Gross Profit and Gross Profit Margin

For more advanced readers who own a business or want to understand how to analyze gross profit margins for companies in which they wish to buy stock, I wrote an essay called A Deeper Look at Gross Profit and Gross Profit Margins explaining how it is possible for a company with low gross profit margins to make more money than a company with high gross profit margins. It is definitely worth studying as this is one of those fundamental, bedrock concepts that you absolutely need understand before you open your own doors. Targeting a gross profit strategy, and sticking with it, can be a powerful way to expand your operations and communicate a consistent pricing philosophy to customers.