Gross Profit

How to Calculate Gross Profit (Step-by-Step)

On the income statement, the gross profit line item appears under the cost of goods (COGS) line, which comes right after revenue (i.e. the “top line”).

• Revenue → The total monetary value of the goods and/or services sold by a company in a specified period, as recognized per accrual accounting standards.
• Cost of Goods Sold → COGS are the direct costs associated with producing a good or delivering a service.

Indirect costs such as operating expenses and non-core expenses do not affect gross profit.

• Direct Costs →  e.g. Direct Materials, Overhead Costs, Direct Labor
• Indirect Costs → e.g. Selling, General and Administrative (SG&A), Research and Development (R&D

Conceptually, the gross income metric thereby reflects the profits available to meet fixed costs and other non-operating expenses.

Companies can increase their gross profits using four primary methods:

1. Increase Average Order Value (AOV) → Requires Pricing Power, Opportunities to Upsell or Cross-Sell, Product Bundling
2. Reduce Inventory Purchase Prices → Requires Buy Power and Negotiating Leverage with Suppliers and Vendors (e.g. High Order Volume, Frequent Orders, Bulk Purchases, Branding)
3. Higher Margin Product/Service Integrations → Integrating Products/Services with Higher Profit Margins into Existing Offerings can Improve Pricing (i.e. Software Capabilities)
4. Economies of Scale → More Units Sold (Higher Output) Can Result in the Incremental Costs Incurred Per Unit to Reduce from the Increased Scale of the Company’s Operations

Gross Profit Formula

The formula for calculating the gross profit is as follows.

As a standalone metric, the gross income is not very meaningful, which is the reason that it must be standardized by converting it into percentage form.

The formula for the gross margin is the company’s gross profit divided by the revenue in the matching period.

The gross margin is the percentage of a company’s revenue remaining after subtracting COGS (e.g. direct materials, direct labor).

Moreover, the gross margin facilitates comparisons among industry peers and comparable companies, as well as for performing year-over-year (YoY) analyses.

Gross Profit Interpretation: Percentage Margin (%)

Classifying a company’s gross margin as either “good” or “bad” is entirely specific to the industry that the company operates within and the related contextual details.

Generally speaking, higher gross margins are more often than not perceived positively, as the potential for higher operating margins (EBIT) and net profit margins in such cases rises.

But to reiterate, comparisons of a company’s gross margins must only be done among comparable companies (i.e. to be “apples-to-apples”).

Gross Profit Example: Apple (NASDAQ: AAPL)

As a real-life example, the gross margin of Apple (NASDAQ: AAPL), which refers to the dollar amount, from fiscal years 2019 to 2021 is as follows.

• 2019 GP → $260,174 million – $161,782 million = $98,392 million
• 2020 GP → $274,515 million – $169,559 million = $104,956 million
• 2021 GP → $365,817 million – $212,981 million = $152,836 million

^{Apple Gross Margin (Source: AAPL 10-K)}

In recent years, Apple shifted its focus from hardware to software sales, especially since it has become increasingly difficult for Apple to provide a sufficient incentive for customers to upgrade to newer hardware (i.e. phone or laptop) models.

Unlike software and related services — which represent sources of recurring revenue — hardware products are one-time purchases.

Therefore, considering the larger total addressable market (TAM) for software, the reasoning for Apple’s shift toward strengthening its online service offerings and integrating the Apple ecosystem (e.g. iOS App Store, iCloud, iTunes, Apple Music, Macs) is not surprising.

Gross Profit vs. Net Income: What is the Difference?

The gross profit metric accounts for only direct costs (i.e. COGS), as mentioned earlier.

On the other hand, the net income — i.e. the “bottom line” of the income statement — is the profit metric that accounts for all expenses, including operating expenses such as COGS and SG&A, as well as non-operating expenses like interest and taxes.

While the gross income metric only accounts for COGS, net income is a levered metric (i.e. post-debt) since it is affected by interest expense and is only attributable to shareholders that own equity stakes in the company.

One major drawback to the net income metric — other than the fact that it is a post-debt profit metric — is that net income can also be distorted by non-operating income / (expenses) such as interest income, interest expense, gains or losses of asset sales, and inventory or PP&E write-offs.

In contrast, a company’s gross profit subtracts just one outflow of cash, the direct costs associated with the core generation of revenue.

The gross income metric is thus far better suited for peer-to-peer comparisons because it is mostly unaffected by financing decisions or discretionary accounting policies (e.g. the useful life assumptions on PP&E that determine the annual depreciation expense, jurisdiction-dependent differences in the tax rate, NOLs).

Forecasting Gross Profit: Percentage Assumption (%)

In order to forecast a company’s gross profit, the most common approach is to make an assumption regarding the company’s gross margin (GM) percentage based on historical data and industry comparables.

The gross margin assumption is then multiplied by the revenue assumptions in the corresponding period.

Since that leaves the cost of goods sold (COGS) line item blank, the next step would be to subtract the projected gross income from revenue, which should result in COGS

An alternative approach is to subtract the gross margin from one to arrive at the COGS margin, i.e. COGS as a percentage of revenue.

The COGS margin would then be multiplied by the corresponding revenue amount.