To begin, Gross Profit is a measure of the financial health of a company. It is defined as the income earned by a company after deducting the costs associated with providing the goods and services. As well, it is sometimes known as gross income.

To calculate gross profit: 

Total Revenue – Cost of Sales = Gross Profit

Some companies list Cost of Goods Sold (COGS) instead of Cost of Sales (COS) on their income statements. COGS is more commonly used in a product or inventory heavy company. COS is mostly used in services heavy companies. It is important to note that the Revenue depends on revenue recognition policies. Cost of Sales (or COGS) depends on accounting policies about what expenses to include in the COS. For instance, are Customer Success Employees’ labour expenses part of providing the product or part of general operating expenses? It is important that a qualified accountant set the accounting policies and ensures they are applied consistently to ensure meaningful trend analysis over time.

You need to understand gross profit for different parts of the business, different types of products or different markets. To do this, you need to create Revenue Accounts for each type as well as matching COS accounts for each type.

Net income is another measure of the financial health of the company. It’s calculated by subtracting the total expenses in a period from the total revenue in the same period. When people speak of Profit or Profitability, they are often referring to Net Income. This is the final and ultimate expression of how profitable a company is. So, Net Income considers all operating expenses, non-operating expenses (such as interest and taxes). The income is sometimes called net earnings.

Net Income = Total Revenue – Total Expenses

Gross Profit calculations depend on accounting treatment of various expenses. In other words; policies and professional judgement about what expenses are administrative expenses vs Cost of Sales. This judgement could influence the final Gross Profit. Net Income does not, as it is the simple summation of all expenses and revenue in a period.

Gross Profit will always be a higher number than Net Income. Starting from Gross Profit, you must subtract all other operating expenses (which reveals Operating Income). Then, subtract all non-operating expenses, such as interest expenses, tax expenses and other expenses to arrive at the Net Income (the bottom line).

When asking the question “if the company sells more volume or increases prices, will it be more profitable?” – a low or negative Gross Profit suggests that no matter the revenue increase, the company will struggle. Basically, comparing Gross Profit vs Net Income is useful to answer the question “is this company efficient/lean?” A high gross profit and low net income could indicate that the company could be overspending on non-essential items. A keen financial analyst will examine to what extent the company is spending on growth vs. inefficient operations.

There is no hard and fast rule about which expenses to include in COGS or COS calculations. Though, these decisions should be made by an accountant with experience in Management Accounting or, more specifically, Cost Accounting. In cost accounting, we examine the costs associated with selling one additional unit of the product (or service). Variable Costs are directly associated with selling one additional unit. Contrarily, Fixed Costs are incurred by the company whether or not they increase sales volume. Variable Costs should be included in COGS (or COS) expense accounts. Fixed Costs should be included in other operating expense accounts. Even so, the line is blurred when we consider semi-fixed or semi-variable costs – a given team can service additional sales volume up to a point, and then additional equipment or additional teams must be onboarded. 

It is most important that these definitions are documented for the specific context of the company and written in to accounting policies, such that trends can be analyzed over time. Practically speaking, business owners and company management want to spend time analysing the story the numbers are telling vs. arguing about what should be included in COS every month.

Gross Profit helps us understand how profitable a company with respect to sales volume. So, will increasing sale volume have an impact on Net Income? A low Gross Profit could indicate that the company needs to increase prices or find cheaper product/service inputs.

Gross Profit expressed as a percentage of Total Revenue is called Gross Margin, or simply ‘margin’. As a result, salespeople who understand the ‘margin’ on each given sale can understand if they’re contributing to healthy Gross Margins for the company. However, aggressive discounting policies can cut into Gross Profit. Therefore, keeping an eye on Gross Profit will give management and business owners immediate and effective tools to influence profitability.

Getting help with Gross Profit

Many clients come to us trying to figure out how to scale their business. One of the first areas we look into is Gross Profit. Talk to us, we’re a CPA firm in Vancouver and we have an office for those looking for Toronto accounting firms too.