Gross profit is a calculation that indicates how much of every sales dollar represents revenues minus inventory cost. Gross profit equals net sales after cost of goods sold is deducted but before other selling and administrative costs are deducted. From gross profit, managers can calculate gross profit rate. The gross profit rate can then be applied at any time to estimate current costs and evaluated over time to measure company efficiency.
The first step in determining gross profit rate is to calculate net sales. Net sales equals total sales revenue from all goods and products minus any allowance for sales returns. For example, say that a business earns $600,000 in revenue from all product sales and expects sales returns to be around 1 percent of total sales. Net sales is $600,000 minus $6,000, or $594,000.
To calculate gross profit, subtract cost of goods sold from net sales. Cost of goods sold equals the product cost of all inventory sold during the accounting period. The three components of product costs are direct labor, direct materials and manufacturing overhead. Direct labor is the salaries, benefits, bonuses and payroll taxes for all workers involved in the actual manufacturing process. Direct materials are any materials purchased to construct or alter the product. Manufacturing overhead represents the other overheard purchases and costs involved in making the product. For example, equipment depreciation, plant manager salaries, factory rent and utilities are all manufacturing overhead. General overhead, such as executive salaries, marketing and sales expense, aren't part of this calculation.
Once you determine gross profit, you can calculate the gross profit rate by dividing gross profit by net sales. For example, say that a company has net sales of $594,000 and cost of goods sold of $300,000. Gross profit is $594,000 minus $300,000, or $294,000. Gross profit rate is $294,000 divided by $594,000, or 0.49. This means that 0.49 cents of every sales dollar represents profit before selling and administrative expenses. Gross profit rate can still be calculated even if gross profit is negative. For example, say that cost of goods sold is $700,000 instead of $300,000. In this scenario, gross profit is ($106,000) and gross profit rate is -0.18. This means that 18 cents of every sales dollar represents cost of goods sold.
Because it's in a percentage format, managers can apply the most recent gross profit rate to evaluate estimated revenues and costs in the middle of an accounting period. For example, say that a company has made $70,000 in product sales so far this period. A manager can multiply products sales by the most recent gross profit rate to determine how much of that $70,000 is profits before selling and administrative expenses. The gross profit rate also indicates how efficient a company is with resources during the production process. A company can also evaluate its gross profit rate year over year to evaluate efficiency is improving or declining.