Often, people use gross margin and gross profit interchangeably, which is a mistake. They both measure similar metrics using a company’s income statement. However, they show profitability differently. Gross margin involves a basic calculation relating to a company’s income, while gross profit consists of subtracting the cost of goods from the revenue.
It’s important to note that there’s a difference between gross profit and adjusted gross income (AGI). While gross profit determines a company’s profitability, adjusted gross income is used to calculate taxable income.
Sometimes, business owners spend copious time browsing through their business’s annual profit and income report. This information is crucial to the business owners as it reflects how well their company generates money from sales. Let’s dive into an in-depth explanation of how to calculate gross margin and gross profit.
How to Calculate Gross Profit
Gross profit is the money a business retains after deducting Costs of Goods Sold (COGS) from the revenue earned. Costs of Goods entail such expenses as packing and shipping costs, direct labor, etc.
Gross Profit = Net Sales – Costs of Goods Sold
Suppose, you generate revenue amounting to $500,000 and have COGS amounting to $200,000 for the same period, your gross profit will be $300,000.
To calculate the adjusted gross income, gross income is reduced by certain items. Some include:
- Health Savings account deductions
- Allowable pension arrangements such as Individual Retirement Accounts
- Paid alimony
- College tuition, fees, and student loans interests
How to Calculate Gross Margin
Unlike gross profit, gross margin is expressed as a percentage. Gross margin is simply the ratio that compares gross profit to revenue. It’s sometimes called gross profit margin.
Gross Margin = Total Sales Revenue – (Cost of Goods Sold / Total Sales Revenue)
Suppose you generate $ 300,000 in gross profit for a period and $600,000 in revenue. To calculate the gross margin, you’ll divide $300,000 by $600,000. In this case, your gross margin is 0.5 percent. Thus your business converted o.5 percent of its periodic revenue into gross profit. It’s expressed as a whole number depending on the currency the company is operating.
Difference between Gross Profit and Gross Margin
Meaning of Gross Profit and Margin
A distinct difference between gross profit and gross margin arises in the definition of the two terms. Gross profit represents the amount that a company retains after subtracting the cost of goods sold from the sales revenue of the company. The cost of goods is the direct costs of producing the goods sold by a company. It entails the cost of materials and labor used to create the products. The price of goods sold excludes indirect expenses such as distribution costs and sales force costs.
In contrast, gross profit margin, or simply, gross margin is the amount that remains after subtracting all production costs and sales of goods and services. It’s important to remember that the gross profit margin is expressed as a percentage.
Purpose of Gross Profit and Gross Margin
In the financial statements, gross profit shows the financial position of the company. The gross margin shows the percentage of the money earned in comparison to the costs incurred. You can use gross profit to calculate the adjusted gross income. This is most relevant if you’re calculating individual tax. Adjusted gross income is calculated by deducting Above-the-line deduction from gross income.
Often, companies in the same industry regularly compete to outdo each other to increase their market share. In the long run, the company grows its profits. Thus, gross margin determines the company that is operating efficiently in that industry. Gross margin records the profit made after a company earns $1 sales. The greater the gross profit margin, the higher the efficiency of the company. Gross profit margin is highly used as an industrial benchmark.
Product Line Determination
Organizations produce a variety of products and services. It enables the companies to determine the profitability of the product or service. Gross margin helps to identify and calculate the gross profit margin for product lines.
To get the profitability and any other information on a particular product, the company can determine the gross margin of each product. However, it is challenging to decide on the total profit of each product line or service. Therefore, gross profit does not offer much information that you can use to determine which products are profitable.
Benefits of Gross Profit and Gross Margin
Gross profits and gross profit margins have specific benefits to the business owner, whose ultimate goal is to manage their company in the most efficient strategy. By analyzing the total profits of your business, you’ll be able to determine the cost of direct costs in the sale of goods and services. For higher profits, business owners introduce measures that enable them to reduce the cost of goods.
On the other hand, gross margin is significant to a business owner in that it ensures the owners use the margin analysis as a measurement technique. In turn, the business owner gets favorable pricing to all customers while achieving a company’s target.
Both gross profit and gross margin are good indicators of a company’s profitability based on their sales and costs of goods sold. However, they don’t include operating expenses, interest and taxes. It is , therefore, advisable as you use gross profit and gross margin, consider multiple financial ratios to extensively analyse a company’s performance. Also, for individual tax purposes, you can use the adjusted gross income