A Closer Look
Gross profits are sales minus all the costs that are directly incurred to make the product (cost of goods sold). These expenses include the cost of raw materials, direct labor and manufacturing expenses. Gross profit is, in a sense, an inflated profit figure because certain other key expenses are not yet deducted. These figures include overhead, payroll, taxation and interest payments; all else being equal deducting these will reveal the net profit.
The gross profit figure reveals the profitability of a company after all the main expenses associated with actually making the product are deducted. So while factory overhead, taxation, and interest expenses are all a part of running the business, they aren’t directly a result of creating the product, therefore, excluding them when calculating gross profit reveals just the cost of creating the finished product and avoids including the other incidental costs such as interest payments on loans.
In essence, gross profit is a measure of production efficiency. Calculating the gross profit forms a base for calculating gross margin and the gross profit ratio. These figures reveal what percentage of revenue is retained after the direct costs are covered. This is an important figure that managers and analysts use to determine how efficiently the core operation of a business is running. For example, if total sales are $10,000 and cost of goods sold is $5,000 then the gross profit margin would be 50% (5,000/10,000)*100; which is not a bad figure.