How gross profit can help you assess the profitability of your company
Gross profit is an important key figure that can be determined from the values of the profit and loss account. It is used to evaluate the profitability of the operational area in a company. We show you here how to calculate gross profit and with which other key figures it is related.
Gross profit is the profit of a company after deducting from its turnover all the costs incurred in producing a product or providing a service. Gross profit is calculated using figures from the profit and loss account and is an important indicator for companies, lenders and investors.
Gross profit is an indicator of how well a company uses its available resources to generate a profit. Thus, it directly reflects the profitability of the company.
While gross profit is calculated by deducting production and distribution costs from turnover, net profit is calculated by deducting all company costs from turnover.
Gross profit is primarily used to assess how well a company is managing its operations and using its resources. Net profit, on the other hand, is used to assess how well a company is positioned financially overall, because it also takes into account the costs for administration, insurance and taxes.
Gross profit is calculated with the following formula:
Gross profit = Net sales - COGS
Net sales stands for net turnover and COGS for cost of goods sold, i.e. the manufacturing and distribution costs for the product.
Gross profit can be used to calculate gross margin or gross ratio, which corresponds to gross profit as a percentage:
Gross margin = (Revenue - COGS) / Revenue x 100
Gross margin can be used to evaluate the efficiency of the company over time by comparing gross margin values from past periods.
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Gross profit can be used to calculate operating profit, which is also known as EBIT (earnings before interest and taxes):
Operating Profit (EBIT) = Gross Profit - Operating Expenses - Depreciation - Amortisation = Net Income + Interest + Taxes
The operating profit thus indicates the performance of the operating area of the company.
If depreciation and amortisation are also included in the calculation, EBIT becomes EBITDA (earnings before interest, taxes, depreciation and amortisation). EBITDA can be calculated like this:
EBITDA = Net Income + Interest + Taxes + Deprecitation + Amortisation
Or expressed with large profit also like this: EBITDA = Gross profit - Operating Expenses + Depreciation + Amortisation
EBITDA is used to evaluate the general financial performance of a company. It can also be used to compare the performance of different companies.
The profit and loss account of a company looks like this:
Revenue: £100,000 Cost of goods sold (COGS): £60,000 Marketing costs: £5,000 Admin costs: £4,000 Depreciation: £2,000 Interest: £1,000
Marketing costs and admin costs together fall under the so-called operating expenses.
With this, we can now calculate various key figures:
Gross profit = Revenue - COGS = £100,000 - £60,000 = £40,000 Gross margin = (Revenue - COGS) / Revenue x 100 = (£100,000 - £60,000) / £100,000 x 100 = 40%.
Net profit = Gross profit - Operating Expenses - Interest - Depreciation - Amortisation = £40,000 - £5,000 - £4,000 - £1,000 - £2,000 - £0 = £28,000
Operating profit = Gross profit - Operating Expenses - Depreciation - Amortisation = £40,000 - £5,000 - £4,000 + £1,000 - £2,000 - £0 = £30,000
EBITDA = Operating profit + Depreciation + Amortisation = £30,000 + £2,000 + £0 = £32,000
Note that when calculating operating profit (EBIT), the amount for interest must be added, as this variable is not taken into account in EBIT.
These examples show that gross profit is a very important indicator that can be used to calculate many other parameters. Since it provides information about the profitability and performance of a company, it is therefore also interesting for investors and lenders, because it shows how successful a company is in its operational area.