Business owners and managers involved in the financial management of a company use a variety of numbers and ratios to assess that company's financial position. Gross profit is a term to describe the money left over from the sale of products after subtracting the cost of goods sold without taking out the money needed to pay operating expenses. Knowing how much is left from each sale to pay salaries and other fixed expenses helps leaders determine the financial health and viability of the operation.
To calculate gross profit, one should first understand what comprises the cost of goods sold. Not every expense a company incurs qualifies for this figure. Only those costs directly related to the production of the product is used. As a rule of thumb, if the cost in question varies in relation to the number of products produced, it is a variable cost, and thus appropriate for inclusion in cost of goods sold.
Production efficiency is determined using this measurement as a base. Gross profit margin, ratio, and percentage all represent the same calculation. These calculations are reached by dividing gross profit by the total revenue. For example, if the gross profit is $1,000 US Dollars (USD) and the total revenue is $2,000 USD, the gross profit margin is 50 or 50%.
Business executives use this margin to evaluate the efficiency of the company as a whole and, in some cases, particular business units or products. As only two variables play a role in this figure, there are only two ways to influence it. An increase in price or a decrease in costs increases gross profit, while a decrease in price or an increase in costs will decrease it.
When tracked over time, increases in gross profit indicate the company is more efficient at making money based upon the products sold. This does not necessarily equate to larger profits for the company, however, because factors like employee salaries, taxes, and rent can increase to eat away at the net profits. On the other hand, if the trend is a steady decrease in gross profit, company officials may deem it necessary to discontinue a product or revamp the way in which they run the company. Gross profit is a required element of the income statement in the United States, and should have a separate line to comply with Generally Accepted Accounting Principles (GAAP) rules and standards.