What is gross profit?
Let’s find out what the definition of gross profit is, how to calculate gross profit,
and why gross profit is important, using real-world examples.
You have probably heard of a company called Tesla!
Here’s the first part of Tesla’s consolidated statement of operations, or income statement.
Gross profit is right here: $6.6B for 2020.
Gross profit is calculated by taking total revenues and deducting total cost of revenues.
$31.5B minus $24.9B = $6.6B.
Basically, revenue is the number of units sold times the selling price,
and cost of revenue is the number of units sold times the cost per unit.
Gross profit is the difference between those two: revenue minus cost of revenue.
Now the term “cost of revenue” might be a new one for you.
This is also known as “cost of sales”, “cost of goods sold”,
or “cost of services sold”.
If you sell products, then those products have a cost of goods sold.
If you sell services, then those services have a cost of services sold.
Because Tesla identifies four types of revenue (automotive sales, automotive leasing, energy
generation and storage, and service and other),
there are also four corresponding types of cost of revenue.
When we review Tesla’s annual report, we will find detailed descriptions explaining
each of these lines.
Let’s review the first, and biggest, of those lines.
Here’s how automotive sales revenue gets recorded: “We recognize revenue on automotive
sales upon delivery to the customer, which is when the control of a vehicle transfers”.
The description of the corresponding cost of automotive sales revenue
is quite a lengthy one.
Some of the key items it includes are: direct parts, material, labor costs, depreciation
of tooling and machinery, shipping and logistic costs,
warranty expenses, and inventory obsolescence charges.
That’s what it takes to build and deliver the car that they sold!
Review Tesla’s annual report, to find the exact definitions of items 2, 3 and 4.
How does gross profit fit into the overall profit and loss statement?
Well, it certainly isn’t the only level of profitability you can measure!
Gross profit is revenue minus cost of revenues.
Income from operations is gross profit minus operating expenses: research and development,
and selling, general and administrative.
Income before income taxes is income from operations
minus interest expense and other income.
Net income is income before taxes minus provision for income taxes.
And net income attributable to common stockholders is net income minus noncontrolling interests.
If you analyze the profit and loss statement of a company, then gross profit in many cases
is an excellent place to start.
If a company is able to grow revenue, and grow gross profit at the same rate or faster
than revenue, then income from operations and net income might grow exponentially.
One important step to take in financial analysis is to make things relative.
What is gross profit as a percentage of revenue?
In other words, what is the gross profit margin percentage?
You calculate gross profit margin percentage by taking gross profit, $6.6B, and dividing
it by revenue, $31.5B. The answer for Tesla in 2020 is 21% gross profit margin percentage.
So is that high or low?
Well, that depends whether you categorize Tesla as a car company and compare them to
other companies in the automotive industry,
or as a tech company and compare them to other tech companies.
Let’s take a look at a tech company you might have heard of called Facebook.
This is its full year 2020 P&L, all the way from revenue at the top
to net income at the bottom.
Now where is gross profit?
This is not listed, Facebook doesn’t provide it to you, but you can easily calculate it
yourself by taking revenue minus cost of revenue.
$86B of revenue minus $16.7B cost of revenue equals $69.3B of gross profit.
To calculate the gross profit margin percentage, we take this $69.3B of gross profit and divide
it by $86B of revenue, and get to a stellar 81%!
Now that’s a very high gross profit margin percentage.
But is it the highest ever recorded?
That’s the topic of a different story!