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Gross Profit

Investing Lesson 4 - Analyzing an Income Statement


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Understanding Gross Profit and Why It Matters to a Business
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, office supplies, electricity, water, rent, postage, furniture, software, or holiday parties for the employees.

When you look at an income statement, GAAP rules require that gross profit be broken out and clearly labeled as its own line so you can't miss it. Still, you should know how to calculate it for yourself so I want to take a moment to teach you the formula:

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

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment. 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.

Although important, one of the bigger problems with gross profit in isolation is that there is some flexibility management can exhibit when determining whether an expense gets put under cost of goods sold section or assigned to selling, general, and administrative expenses, which is found further down the income statement. It's not absolute, and you can't get away with a lot of abuse in most situations without raising a lot of red flags, but it's entirely possible if you were looking at two otherwise identical companies, one would report higher gross profit than the other, though their bottom-line net profit (which we will discuss later), would remain the same. It comes down to judgment in identifying the expenses that are a necessary component of the actual product or service itself. Reasonable people can, and do, disagree on where and item should go in the income statement.

An Example of Gross Profit from One of My Companies
To help illustrate the concept of gross profit in a real world situation, I'll give you an example from one of the businesses in which I used to have a substantial ownership stake but have since divested. The company is called Kennon & Company. It sells a lot of luxury shaving sets both online and through its retail store. If a customer purchases an imported British luxury shaving set for $315, our cost of goods sold would typically be $160 for the set itself, $20 for various merchant fees, service charges, and bank processing costs, and $20 for shipping and handling into our retail store.

This results in revenue of $315 - cost of goods sold of roughly $200 for a gross profit of $115 per every shaving set sold. If we were to drop the price 20% for a sale, the calculation would change to $252 revenue - $200 costs of goods sold = $52 gross profit. The $115 in the first case, or the $52 in the second, is the money we have available to pay our sales associates, taxes, office supply expense, and computer costs. The higher the gross profit, the more money we would have had for expansion, salaries, or dividends to shareholders. (Actually, the business was structured as a limited liability company, so there were "unit holders" or "members", not shareholders as the latter is technically a reference to owning a piece of a corporation.)

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 reading 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 strategy to expand your operations and communicate a consistent pricing philosophy to customers.

Next page > Calculating Gross Margin > Page 1, 2, 3, 4, 5, 6, 7, more >>

This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.

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