What is Gross Profit?
Gross Profit represents the earnings remaining once a company’s direct costs, i.e. cost of goods sold (COGS), have been deducted from revenue.
More specifically, the gross profit metric is the income left over after all direct expenses related to the production of a good or delivery of a service to generate sales have been subtracted from revenue.
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How to Calculate Gross Profit
On the income statement, the gross profit line item appears under the cost of goods (COGS) line, which comes right after revenue (i.e. the “top line”).
- Revenue → The total monetary value of the goods and/or services sold by a company in a specified period, as recognized per accrual accounting standards.
- Cost of Goods Sold → COGS are the direct costs associated with producing a good or delivering a service.
Indirect costs such as operating expenses and non-core expenses do not affect gross profit.
- Direct Costs → e.g. Direct Materials, Overhead Costs, Direct Labor
- Indirect Costs → e.g. Selling, General and Administrative (SG&A), Research and Development (R&D
Conceptually, the gross income metric thereby reflects the profits available to meet fixed costs and other non-operating expenses.
Companies can increase their gross profits using four primary methods:
- Increase Average Order Value (AOV) → Requires Pricing Power, Opportunities to Upsell or Cross-Sell, Product Bundling
- Reduce Inventory Purchase Prices → Requires Buy Power and Negotiating Leverage with Suppliers and Vendors (e.g. High Order Volume, Frequent Orders, Bulk Purchases, Branding)
- Higher Margin Product/Service Integrations → Integrating Products/Services with Higher Profit Margins into Existing Offerings can Improve Pricing (i.e. Software Capabilities)
- Economies of Scale → More Units Sold (Higher Output) Can Result in the Incremental Costs Incurred Per Unit to Reduce from the Increased Scale of the Company’s Operations
Gross Profit Formula
The formula for calculating the gross profit is as follows.
Gross Profit Formula
- Gross Profit = Revenue – Cost of Goods Sold (COGS)
As a standalone metric, the gross income is not very meaningful, which is the reason that it must be standardized by converting it into percentage form.
The formula for the gross margin is the company’s gross profit divided by the revenue in the matching period.
Gross Margin Formula
- Gross Margin = Gross Profit ÷ Revenue
The gross margin is the percentage of a company’s revenue remaining after subtracting COGS (e.g. direct materials, direct labor).
Moreover, the gross margin facilitates comparisons among industry peers and comparable companies, as well as for performing year-over-year (YoY) analyses.
Interpreting Gross Margin
Classifying a company’s gross margin as either “good” or “bad” is entirely specific to the industry that the company operates within and the related contextual details.
But to reiterate, comparisons of a company’s gross margins must only be done among comparable companies (i.e. to be “apples-to-apples”).
Gross Profit of Apple (AAPL) Example
As a real-life example, Apple’s gross margin, which refers to the dollar amount, from fiscal years 2019 to 2021 is as follows.
- 2019 GP → $260,174 million – $161,782 million = $98,392 million
- 2020 GP → $274,515 million – $169,559 million = $104,956 million
- 2021 GP → $365,817 million – $212,981 million = $152,836 million
Apple Gross Margin (Source: AAPL 10-K)
Gross Profit vs. Net Income
The gross profit metric accounts for only direct costs (i.e. COGS), as mentioned earlier.
On the other hand, the net income — i.e. the “bottom line” of the income statement — is the profit metric that accounts for all expenses, including operating expenses such as COGS and SG&A, as well as non-operating expenses like interest and taxes.
While the gross income metric only accounts for COGS, net income is a levered metric (i.e. post-debt) since it is affected by interest expense and is only attributable to shareholders that own equity stakes in the company.
One major drawback to the net income metric — other than the fact that it is a post-debt profit metric — is that net income can also be distorted by non-operating income / (expenses) such as interest income, interest expense, gains or losses of asset sales, and inventory or PP&E write-offs.
In contrast, a company’s gross profit subtracts just one outflow of cash, the direct costs associated with the core generation of revenue.
The gross income metric is thus far better suited for peer-to-peer comparisons because it is mostly unaffected by financing decisions or discretionary accounting policies (e.g. the useful life assumptions on PP&E that determine the annual depreciation expense, jurisdiction-dependent differences in the tax rate, NOLs).
Forecasting Gross Profit
In order to forecast a company’s gross profit, the most common approach is to make an assumption regarding the company’s gross margin (GM) percentage based on historical data and industry comparables.
The gross margin assumption is then multiplied by the revenue assumptions in the corresponding period.
- Forecasted GP = GM % Assumption × Revenue
Since that leaves the cost of goods sold (COGS) line item blank, the next step would be to subtract the projected gross income from revenue, which should result in COGS
An alternative approach is to subtract the gross margin from one to arrive at the COGS margin, i.e. COGS as a percentage of revenue.
The COGS margin would then be multiplied by the corresponding revenue amount.
- Forecasted GP = (1 – GM % Assumption) × Revenue
Gross Profit Calculator — Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Gross Profit Example Calculation
Suppose we’re tasked with calculating the gross profit and gross margin of Apple (AAPL) as of its past three fiscal years.
The historical net sales and cost of sales data reported on Apple’s latest 10-K is posted in the table below.
|Apple (AAPL) Historical Data|
|($ in millions)||2019A||2020A||2021A|
|Total Net Sales||$260,174||$274,515||$365,817|
|Cost of Sales:|
|Total Cost of Sales||($161,782)||($169,559)||($212,981)|
In our model, we’ll calculate the gross profit and gross margin metrics separately for the products and services division.
- Products Gross Profit:
- GP, 2019A = $68,887 million (32.2% Gross Margin)
- GP, 2020A = $69,461 million (31.5% Gross Margin)
- GP, 2021A = $105,126 million (35.3% Gross Margin)
- Services Gross Profit:
- GP, 2019A = $29,505 million (63.7% Gross Margin)
- GP, 2020A = $35,495 million (66.0% Gross Margin)
- GP, 2021A = $47,710 million (69.7% Gross Margin)
The differences in gross margins between products vs. services is 32%, 35%, and 34% in the three-year time span, reflecting how services are much more profitable than physical products.
In the final part of our modeling exercise, we’ll calculate the total gross profit and gross margin of Apple, which blends the profits (and margins) of both the products and services divisions.
- Total Gross Profit:
- GP, 2019A = $98,392 million (37.8% Gross Margin)
- GP, 2020A = $104,956 million (38.2% Gross Margin)
- GP, 2021A = $152,836 million (41.8% Gross Margin)
From 2019 to 2021, Apple’s gross margin averaged approximately 39%, but from our analysis, we know that its margins are particularly weighted down by the products division.
Apple Hardware → Software Focus
In recent years, Apple shifted its focus from hardware to software sales, especially since it has become increasingly difficult for Apple to provide a sufficient incentive for customers to upgrade to newer hardware (i.e. phone or laptop) models.
Unlike software and related services — which represent sources of recurring revenue — hardware products are one-time purchases.
Therefore, considering the larger total addressable market (TAM) for software, the reasoning for Apple’s shift toward strengthening its online service offerings and integrating the Apple ecosystem (e.g. iOS App Store, iCloud, iTunes, Apple Music, Macs) is not surprising.