Unlike net profit – which represents the amount a company earns after subtracting all business expenses – gross profit represents profit after subtracting only the cost of goods sold. It's the basis for a company's gross margin and can aid in inventory calculations.
Gross profit is equal to the net sales minus the cost of goods sold. The net sales is a company's sales revenue minus sales returns. The cost of goods sold is the cost of all inventory sold, including both fixed costs and variable costs. As the name implies, fixed costs are static and don't tend to change based on production. For example, facility rent, utilities and facility manager salaries tend to be fixed costs. Variable costs, on the other hand, are the costs that change based on how much you're producing. Manufacturing labor, supplies, packaging and shipping costs are all variable.
Using gross profit, managers can calculate useful ratios to help them understand profitability. The most common variation on gross profit is gross margin, which represents what amount of every sale becomes gross profit. Gross margin is calculated by dividing gross profit by net sales for a given period. For example, if net sales were $500,000 and cost of goods sold was $100,000, gross profit is $400,000. The gross margin equals 80 percent.
Gross profit is often used to estimate the cost of goods sold and inventory levels in between reporting periods. It's useful when management needs to estimate inventory levels but can't perform a physical count. To calculate the cost of goods sold using the gross profit method, subtract the gross margin ratio from one and then multiply that figure by the cost of goods available for sale. The cost of goods available for sale is the beginning inventory plus purchases. For example, a business has a gross margin of 60 percent, has a beginning inventory of $300,000, and has purchased $100,000 in inventory materials this period. The estimated cost of goods sold is 40 percent multiplied by $400,000, or $160,000. The difference between cost of goods available for sale and cost of goods sold is current inventory. In this case, it's $240,000.
The way a company chooses to value its inventory affects its gross profit calculation. Managers can choose to use "last in, first out" (LIFO), "first in, first out" (FIFO), or average cost to calculate cost of goods sold. LIFO assumes that the most recent inventory purchases are the ones sold first. In contrast, FIFO assumes the oldest inventory is what's sold. Average cost calculates cost of goods sold using the overall average inventory costs. Depending on a manager's choice, gross profit can vary wildly. For example, suppose a company's oldest inventory cost $200, the newest cost $400, and it has sold one unit for $1,000. Gross profit would be calculated as $800 under LIFO and $600 under FIFO.