Generally Accepted Accounting Principles (GAAP) are the guidelines for financial reporting, and all companies must prepare financial statements in accordance with them. According to GAAP, a business's gross profit is the difference between revenues from sales and cost of goods sold (COGS). Gross profit is calculated by adding together all revenues from operating activities and subtracting costs associated with generating those revenues; the figure is a meaningful financial metric for stakeholders.
Cost Of Goods Sold (COGS)
Gross profit only accounts for costs directly attributable to goods and services sold, and does not consider indirect costs, such as utilities, salaries and factory overhead. For example, a company selling plastic toys would include the cost of plastic raw materials in its cost of goods sold but not the salary for the factory's nightwatchman. Consequently, all indirect costs must be subtracted from the gross profit figure to determine actual earnings.
The gross profit figure for a period appears in a company's financial statement, known as the income statement. Operating expenses not included in the cost of goods sold, such as insurance, salaries, advertising, delivery and rent expenses, and general administrative expenses are subtracted from gross profit to determine the income from operations. Finally, other revenues and losses are incorporated into the income from operations, which determines the taxable income figure. The money left over after paying taxes is the company's net profit.
Gross Profit Margin
Gross profit represented as a percentage of revenue is known as the gross profit margin--a useful indicator of a company's financial health. The gross profit margin shows the proportion of revenues that are left over after considering the cost of goods sold. The gross profit margin is the funds source for meeting additional expenses and adding to savings in the company's retained earnings account. Within the same industry, a company with a higher gross profit margin is more efficient than one with a lower gross profit margin.
Gross profit and gross profit margin can be used to compare companies with one another or to industry averages. In general, for companies operating within the same industry, the one with the higher gross profit or gross profit margin is more efficient because it is able to earn more money for every dollar of sales. If a company's gross profit margin is lower than the industry average, it means the company procures raw materials at a higher cost than its competitors or sells its products with a low markup.
Gross profit figures may be used internally to evaluate performance of different divisions within the company and to determine trends over time. In a large company manufacturing many different products in different departments, comparing gross profit for each division enables management to determine which divisions are performing efficiently and which need scrutiny. A company may also compare its gross profits for a period with a base period. For example, a company may compare its 2010 figures with figures for earlier years to analyse profitability and operational performance trends over time.