# 3. Calculating Gross Profit

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Overview

Gross profit is calculated by subtracting Cost of Goods Sold from Revenue. In this lesson we examine trends in Gross Profit and Gross Margin for MarkerCo

Lesson Notes

Cost of Goods Sold

- Cost of Goods Sold are expenses that can be directly matched to revenue (e.g. raw materials)
- Cost of Goods Sold vary a lot by industry (e.g. retail very high, software very low)
- Revenue - Cost of Goods Sold = Gross Profit

Gross Margin and Matching Principle

- Gross Margin tells us how much gross profit is created for every dollar of revenue
- Gross Margin = Gross Profit / Revenue
- The Matching Principle directs a company to report an expense in the same period as the related revenue

Transcript

In the previous lesson, we looked at revenue in the Income Statement, and how it was different to cash and sales. In this lesson, we're going to look at the cost of sales and gross profit. The cost of goods sold includes expenses that can be directly matched with associated revenues, hence the common term, matching principle. For example, we'll assume that MarkerCo has a consulting contract for 80,000 dollars this year, and has hired a contractor costing 30,000 dollars to complete the work. In this case, the 30,000 dollars would be the cost of goods sold. Now lets take a hardware example of MarkerCo's capacity division. In 2015 the business bought 3,500 capacitors at 50 dollars per set. 2,000 capacitors at 45 dollars per set, and 1,400 capacitors at 40 dollars per set. Only the capacitors at the 50 dollar cost were sold in 2015. So what is the cost of goods sold? Well, according to the matching principle, we only incur costs of goods sold when it's matched to revenue. So because revenue is only incurred on the 3,500 capacitors that were bought for 50 dollars, our total cost of goods sold for capacitors was 175,000 dollars.

The remaining capacitors will sit on our balance sheet, held as inventory. Now that we understand cost of goods sold, lets move on to gross profit. From MarkerCo's accounts, we can see that the overall gross profit for the business has increased over the past four years. However, we really want to look at gross margin, which is the gross profit divided by the revenue. So lets calculate that now. So I'll add a new row with Alt + I, R.

I'll write gross margin.

And calculate gross margin by dividing the profit by the revenue.

I copy across with Ctrl + R. And convert to percentage.

I'll now format these cells by putting them in italics and removing the bold. And as you can see, the gross margin for the business has grown from 57% to 61% over the last few years. The gross margin tells us how much gross profit is generated from each dollar of revenue. If gross margin increases, it means that we are controlling our matching costs well. If our gross margin decreases while our company is growing, it may mean that we are pursuing less profitable customers as our business expands. Typical gross margins can vary enormously by industry. Software businesses often have very high gross margins, because the cost of manufacturing and delivering an additional software sale is very low. Retail, on the other hand, has very low gross margins, because the retailers must purchase inventory from wholesalers before selling it to customers. Lower gross margins don't necessarily mean that a company has a bad business. It just means that this particular industry has low gross margins. What's more important than your gross margin, is your gross margin relative to your peers'. In this chart, I'll show MarkerCo's consulting gross margin relative to its competitors. As you can see, MarkerCo has the potential to increase prices, and/or reduce costs, to come in line with the industry average. Costs that can not be directly matched to revenue are called period costs, or operating expenses. We'll discuss these in detail in the next lesson.

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