A company’s gross profit, sometimes referred to as gross income, is the difference between the business's sales revenue and all expenses related to its costs of production, which generally consist of variable costs rather than fixed costs.
In other words, it involves taking the total sales revenue and subtracting all the production costs, also known as the cost of goods sold, which can be affected by different factors, including the chosen inventory valuation method, e.g., FIFO or LIFO.
Gross profit is sometimes used interchangeably with gross margin, which is the gross profit divided by the total sales revenue, then multiplied by 100. Gross profit is expressed as an amount in currency, while gross margin is expressed as a percentage.
Although the two terms don’t have the same meaning, they’re both helpful for measuring a business’s operational performance.
The higher the gross profit is, the more it indicates that the company has sufficient resources to cover its expenses.
It should be noted, however, that gross profit takes into account only those operating revenues and expenses that can be disbursed, i.e., those that result in a cash flow. This is different from net profit, which takes all company expenses into account.
Provisions and depreciation, as well as transfers from one financial year to another, aren’t considered. They only appear at the operating income level.
Gross profit makes it possible to do the following:
- pay shareholders and partners in the form of dividends and
- develop the company by investing.
In addition, gross profit helps measure a company's self-financing capacity.
To do this, take the gross profit and subtract provisions for risks, depreciation, bank interest, and corporate tax.
In general, for a meaningful analysis of gross profit, it’s preferable to compare this figure to other indicators, such as the ratio between gross profit and invested capital, or between gross profit and generated revenue.
This provides an excellent view of the economic profitability of the committed capital and accurately measures the productivity of the investments made.
