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What is Gross Profit And Why Is It An Important Mesaure?

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Gross Profit is one of the most important measures to determine the profitability and the financial performance of a business. It reflects the efficiency of a business in terms of making use of its labor, raw material and other supplies. Thus, its increase or decrease over a period helps in determining the reasons causing such a fluctuation. This helps the business in taking corrective action in case there is a negative change in Gross Profit.

It is one of the items appearing in the income statement of a business. So, before we head towards understanding its calculation, let’s first try to understand what is Gross Profit?

What is Gross Profit?

It is an item that appears in the Trading and P&L Account of a company. It is the difference between net sales revenue and cost of sales of a business. Here, the net sales revenue refers to the total revenue less the cost of sales returns, allowances and discounts. Whereas, the cost of sales refers to all the costs incurred to create a product or a service.

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How To Calculate Your Gross Profit?

Gross Profit Example

Following are the financial highlights of Wipro as per the annual report 2018:

Table explaining what is gross profit by taking the figures of Wipro from its annual report.

Now, the financial highlights in the annual report show that the Gross Profit of Wipro for the year 2018 stood at Rs 159,296 million. This has increased from previous year’s gross profit that stood at Rs 158,858 million. As we can see, it is calculated by using the Gross Profit Formula. This involves subtracting cost of revenues from the total revenues. Accordingly, the Gross Profit for the year 2018 is Rs 544,871 million and for 2017 is Rs 550,402 million. Thus, it is clear that the Gross Profit for the current year has increased as compared to the previous year.

Gross Profit Analysis

As we can see, there is a decline in the total revenue in the current year as against the previous year. The reasons cited for such a decline have been three. First, in the Communication segment, one of the clients declared bankruptcy and few large projects experienced ramp downs. Second, revenue from the Healthcare and Lifesciences verticals also declined. This was due to uncertainties around regulatory changes relating to the Affordable Care Act. Also, there was appreciation of the Indian Rupee against currencies other than US dollars that hit the revenues negatively. Last, Wipro chose to being a system integrator. This means the company chose to provide IT products as a complement to its IT services offerings rather than selling standalone IT products.

All this lead to a decline in the consolidated revenue of Wipro for the year ended March 31, 2018. Furthermore, it even impacted the operating margins of the company in a negative way for the current year.

Additionally, if we look at the gross margin figures, the same increased to 29.4% in 2018 as against 29.1% in 2017.

Now, what is the importance of calculating these figures is something that we will discuss after a while.

Why Gross Profit is an Important Measure?

When analyzing the profitability and financial performance of an entity, it is important to consider Gross Profit. This is because it demonstrates the efficiency of the business in making use of its labor, raw material and other supplies.

Now there are a variety of reasons that can impact the Gross Profit of your business. This change can be due to:

  • Changes brought about in the products that lead to charging high prices
  • Efficiency in managing the business that results in low cost sales
  • Certain changes brought about in few of the accounting policies that lead to moving expenses from cost of sales to overheads or vice versa
  • Purchasing raw materials at a low cost as a result of vertical integration of business

Considering the example of Wipro, the year 2018 experienced a decline in total revenues and hence Gross Profit. The underlying reasons for the same were:

  • One of the clients in the communication segment declaring bankruptcy and few large projects experiencing ramp downs.
  • Revenues from Healthcare and Lifesciences verticals declining due to uncertainties around regulatory changes relating to the Affordable Care Act.

Therefore, it is quite apparent that Gross Profit is an important measure. It helps us figure out the underlying reasons as to why there has been a change in the profitability of the business. As a result, it helps us in undertaking steps to correct the areas that impact a company’s efficiency.

Important Profitability Ratios Concerning Gross Profit

The accounting ratios are an important tool in analyzing the financial statements of a business. The profitability ratios, also known as performance ratios, help in determining the earning capacity of your business. These ratios let you know the efficiency with which the resources of your business are utilized.

The important ratios that are based on Gross Profit are Gross Profit Ratio and Gross Profit Margin.

Gross Profit Ratio

Gross profit ratio showcases the relationship between Gross Profit and Net Revenue of your business. It reveals the amount of Gross Profit realized as a percentage of revenue from business operations This ratio is computed as follows:

Gross Profit Ratio = (Gross Profit/Net Revenue of Operations) × 100

The Gross Profit ratio indicates the amount of profit that is available to cover operating and non-operating expenses of your business. Change in gross profit ratio reflect the changes in the selling price or cost of revenue from operations or a combination of both. If this ratio is low, it indicates unfavourable purchase and sales policy. But if the gross profit ratio is high, it is a good sign. This is because it indicates that more profit is available to cover operating and non-operating expenses of your business.

Gross Profit Margin Ratio

Gross Profit refers to the difference between a company’s revenues and cost of sales, or cost of goods sold. Here cost of goods sold represent the expenses related to:

  • labor
  • raw materials and
  • manufacturing overhead involved in the production process.

Such an expenditure is deducted from the company’s net sales/revenue, which results in a company’s gross profit.

Now, gross profit margin is a ratio that shows the relationship between a company’s gross profit and its net revenue. It is used to analyze how efficiently a company is using its (1) raw materials, (2) labor and (3) manufacturing-related fixed assets to generate profits. Thus, gross profit margin is calculated as under:

Gross Profit Margin = Gross Profit/Net Sales (Revenues)

A higher percentage of gross profit margin indicates that the gross profits earned by the company are favorable. Such a ratio is majorly impacted by increasing or decreasing raw material costs. Retailers or service businesses that do not have a production process don’t have a cost of sales exactly. In such cases, the expenses are recorded as cost of merchandise or cost of services. With these types of companies, the gross profit margin does not carry the same weight as a producer type company.