The profitability ratio called gross profit (also known as gross profit margin) is used to calculate the percentage of sales that are exceeding the costs of the sold goods. It all boils down to management, as this ratio shows if a company is using its labor and materials to produce certain products and sell them profitably – the higher the profit, the better the management.
The gross profit is something very simple – basically, it’s what’s left for the company to use after the expenses that go into manufacturing are paid off. Usually, these expenses are, as we mentioned before, direct labor and raw materials.
Understanding the Gross Profit
The gross profit ratio is able to show if the core business activities of a company are profitable or not. Of course, when calculating this ratio, the indirect costs that a company has to pay off are not taken into account.
Investors and the company’s management are thus able to determine if the company is efficient at producing and selling its goods – after all, this is everything that matters in regard to a business.
The health and status of a certain company are measured better when looking at its gross profit rather than net income. For example, a good net income could even mean that the company/ business is already on its way out, as it can hide a negative gross profit percentage.
Therefore, a company can lose money on every single product they manufacture – and have a negative gross profit percentage – but make just enough net income only via one-time operations to keep itself on the track.
Due to the aforementioned reason, the gross profit ratio will be almost always shown on the income statement’s front page.
The Formula of Gross Profit
Rounding up the gross profit of a company is quite easy. All you have to do is to subtract the total costs of goods sold from the total sales – intuitive, right?
Both of the values that you need for this equation can be found on the income statement. However, there are times when the costs of goods sold will be separated into the respective categories – direct labor and raw materials, for example. You just have to add them up, no big deal.
On the other hand, if you want to round up the gross profit percentage of your company, you will have to rely on another equation, which is just as simple as the previous.
You have to subtract the costs of goods sold from the total sales and then divide the result by the company’s total sales.
So, if a company wants to see how profitable their product is, they just have to calculate the gross profit – or the gross profit percentage. Moreover, this ratio can also be used to predict the company’s future activities and create its budgets as well.
If a company knows exactly what its gross profit is, it can easily manage and deal with its expenses in order not to go over a certain amount. For example, if your gross profit is $10 million,
then you’ll have to keep your expenses under this amount if you or your company want to be profitable all year long.