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Gross Profit and Gross Profit Margin

What's the difference between gross profit and net income? Net income is your bottom line, what did you make after you take into account all of your expenses? Gross profit on the other hand only looks at certain expenses.




Revenue

Your first step in determining your gross profit is finding your revenue. Revenue is the amount of money you made. Revenue can be generated from operating, financing, and investing activities. We want to limit the revenue to that from operating activities. Operating activities are the regular activities you perform in the operation of your business. So we're going to count the revenue generated from things like selling your product or services. We're are not going to count revenue such as interest you made from loaning someone money, that is not an operating activity (unless you are in the business of loaning people money).

Expenses

We only consider costs that we can directly associate with the production of goods we have sold or the cost to provide services we have sold. These expenses are considered or cost of goods sold. These include costs such as the materials to make the product and the direct labor. Labor that is not directly tied to the production of a product or the service is not considered a direct cost. These expenses are considered overhead and are not part of gross profit.

The Calculation

To calculate gross profit you take the revenue from operating activities and subtract the direct costs or cost of goods sold. This is the amount you make from the sale of your products or services without considering your overhead. To calculate gross profit margin though take the direct costs and divide them by the total offering revenue and multiply by 100. This percentage is the percent of your selling price that is gross profit. Typical percentages vary by industry and business model.

What Do You Do With This Information?

Gross profit is a management tool. If your gross profit is lower than your target you need to either raise your selling price or decrease the direct costs that are going into your product/service. This can be done by purchasing less expensive material, decreasing direct labor, etc. On the other hand if your net income is suffering but your gross profit numbers look good the issues are your indirect costs. These are your overhead costs and are things like your management costs, utilities, insurance expenses, advertising, etc. Identifying where the problem lies allows you to correct the issue.


Gross profit and gross profit margin are a good indicator of the efficiency of your production. They can clue you in on the pricing of your product compared to the manufacturing process or the pricing of your services compared to your direct cost to provide those services.