Gross income is an income statement entry that reflects total revenues minus the cost of goods sold (COGS). Simply put, it’s the revenue from sales minus the cost of those products.
Gross income is also referred to as gross profit. It tells you how much money a company would have made if there were no other charges. Such as operating expenses, interest payments, and taxes.
Gross income is important to you because it reflects the core profitability of a company before overhead costs. It can also illustrate the financial success of a specific product or service.
In a broad sense, gross income simply shows how much money a company makes against the cost of a product. This allows a company to interpret and project profit potential.
When you look at an income statement, gross income (gross profit) is broken out and clearly labeled on its own line. So it’s easy to find:
Cost of Goods Sold (COGS)
The cost of goods sold is the cost of sales. This includes the raw material and labor required to bring a product to the market. It is one of the two essential halves of a gross income calculation.
Before a product is sold, it sits on the company’s books as an asset. You can see it on the balance sheet as inventory. So inventory is important to manage, as there will be added costs to storing a product for long periods.
Once the inventory is sold, the product’s cost and the costs associated with producing it are expensed through the cost of goods sold (COGS) account on the income statement. Specifically, the formula for COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory
In other words, cost of goods sold is what the business held in inventory at the start of the period (usually year), plus what they purchased to add to it, minus whatever inventory remains at the end of the period, since obviously whatever remains on the shelves wouldn’t qualify as goods sold. Beginning inventory is an important factor that must be counted because, as noted earlier, storing product costs money over time.
You may not even need to ever calculate cost of goods sold, and can simply read it on income statements. Bottom line, there are only two determinants of gross income:
- Sales or total revenue
- The cost of goods sold (COGS)
A company can increase or improve gross profit in various ways:
- Renegotiating contracts with suppliers to lower inventory costs
- Streamlining the production process to lower costs
- Technology to automate process flows and lower labor costs
The cost of goods sold (COGS) is comprised of different expenses relating to producing a product. Finding ways to cut those specific costs will increase gross income and therefore gross income margin as well.
How to Find Gross Profit Margin
Gross income is used to calculate gross profit margin. You can do this by dividing gross income by total revenue. This gives you the percentage of revenue retained after accounting for the cost of goods sold.
Essentially it shows the markup on the product or service a company is selling and gives you a common and basic means of measuring business profit.
Gross profit margin is important because it is the starting point toward achieving a healthy net profit.
A company with a high gross profit margin will be better positioned to have a strong operating margin and strong net income.
For a newer company, the higher the gross profit margin, the faster it can reach the break-even point.
This is important because it can then begin earning profits. Giving it the resources to grow. As well as provide you with a return on your investment.
Rising cost of goods sold (COGS) will lower the margin. Margins can therefore be improved by cutting production costs and finding efficiencies.
Revenues on the other hand will affect margins through pricing strategy. With competition ultimately driving how the margin reacts to the consumer buying habits.
What Is Pricing Strategy?
Just like it sounds, pricing strategy is how a business picks an optimal price for inventory, somewhere between what the customer is willing to pay and what the business needs to sell it at to stay afloat. Pricing strategies vary from business to business, taking into account profit potential, shareholder interests, consumer expectations, and market demand.
Gross Income and Pricing Strategies
The gross margins are often determined by pricing strategies. Typically the way a company prices a product is based on the competitive market.
Companies will often price similar to the competition, accepting the standard margins in the industry. Marketing is an important part of this strategy. As they need to make their products stand out in order to drive sales.
In some cases, it may pay to price lower than the market. This strategy, while producing a lower gross margin, will potentially lead to increased sales from having the best price point in the market. An example of this strategy would be Walmart.
Walmart is famous for its business strategy to provide the lowest prices in the market. They stress their margin to provide a low price point and rely on high sales to produce profits from the lower margins.
Another strategy is to price higher than the market in order to maximize gross profit margins. A high pricing strategy is often accompanied by a major branding campaign.
In this case, the company is really selling the brand as much as the product itself. This allows the company to capture sales at a higher price.
Examples of this are Nike and Apple. They have created strong brands and have proven the ability to command higher prices than many of their competitors.
Nike uses emotional branding to set itself apart from the competition.
Apple has created a clean form and instinctive use in their products. As well as creating a brand known for innovation and quality.
They have both provided the idea of brand quality and popularity in order to command a higher price and therefore have a higher gross profit margin.
A company’s gross profit margin impacts its cash flow. Companies typically spend significantly on inventory costs to make or acquire products.
When they sell the inventory for a profit, they are converting each unit into more cash than they originally invested.
Decisions to invest cash in business expansion are easier when there is confidence in the ability to convert inventory and sales into profit.
A company’s knowledge of the gross margins and sales trends will help drive their cash flow and reinvestment strategies.
Stable margins are ideal. Fluctuating margins can show problematic areas of business.
Watching margins closely can lead to cost analysis in order to find inefficiencies. Fixing these can lead to lower costs and increased profitability.
Using Gross Income for Benchmarks and Comparisons
Profit margins vary widely by industry and by product type. Plenty of data exists to compare the margins of competitors.
Calculating gross profit margin allows you to compare similar companies to each other and to the industry as a whole to determine relative profitability.
Companies with higher gross income margins have a competitive edge over rivals.
They may charge a higher price for their products leading to higher revenues. Or they may pay less for materials and labor to make the products leading to lower COGS.
In the example above you can see that the industry has an average gross profit margin of 21%.
By comparing each of the above companies to the industry average, you can see how they are performing relative to peers. You can also simply look at each company directly compared to the other.
Looking at gross profit margin each of these ways can help when deciding where to place your money.
Gross income (gross profit) is a well-known entry on the income statement, as it represents the core profitability of a company and its products. It is calculated by subtracting the costs of goods sold (COGS) from the total revenue.
A company can use gross income to calculate the gross profit margin which provides a common way to analyze gross income. It can be used in comparison to direct competitors as the margins tend to be similar within industries.
By watching gross income and profit margin, a company will know when to look deeper into the expenses and costs to find reasons for fluctuations. Also, it will benefit a company to know when they are running at a lower margin than competitors. This will allow them to analyze why and find solutions.
There are many reasons for you to watch gross income and profit margin. Watching for trends to see improving or deteriorating margins can speak volumes on the management and future of the company’s income.
Comparing gross income margins of companies within an industry will give you a view of which ones are performing the best. In the end, gross income and margin comparison will help you make the most informed investment decisions.
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