Definition: Gross profit, also called profit margin, is a financial ratio that measures the amount of sales that exceed the cost of goods sold. In other words, it calculates the amount of sales remaining after all of the costs related to these are paid. The gross profit equation is calculated by subtracting the cost of goods sold from the net sales.
What Does Gross Profit Mean?
Management uses the gross profit to gauge how profitable a department or the company as a whole performs during a period. Since the GP is the income left over to pay for all of the operating costs, managerial accountants tend to focus on ways to minimize cost of goods sold and operating expenses.
Gross margin usually refers to company performance at a department or entity level. Profit margin, on the other hand, typically refers to the amount of profit made on a per unit or per transaction basis. For instance, a piece of inventory that cost $10 and retails for $50 has a $40 profit margin or 80 percent profit margin percentage.
Let’s take a look at an example.
Big Joe’s, Inc. is a clothing store in a local mall. It sells plus sized clothes and other accessories. During the year, it purchased inventory for $100,000. The beginning inventory was $75,000 and the ending inventory was $90,000. This means the cost of goods sold for the period was $85,000 (75,000 + 100,000 – 90,000). At the end of the period, Joe managed to generate $150,000 of sales.
Big Joe’s gross margin is $65,000 ($150,000 – $85,000). This means that after Joe pays for the inventory he sold during the year, he has $65,000 left over to pay operating expenses like salaries, rent, utilities, and taxes. A higher GP lets Joe maintain higher operating expenses.