Gross profit is the revenue earned by a company after deducting the direct costs of producing its products. For example, if it costs $15,000 to produce a car, and the car sells for $20,000, the difference of $5,000 is the gross profit on that one car. Gross profit, sometimes referred to as gross margin, is a company's total revenue after subtracting the cost of goods sold.
Typically, depreciation and amortization are not included in gross profit and are treated as separate line items on an income statement. However, there are situations wherein depreciation is included in the cost of goods sold, which is used in calculating gross profit. Below are the two main components of gross profit; revenue and cost of goods sold.
Components of Gross Profit
Revenue is the total amount of income generated from sales in a period. Revenue is also called net sales because discounts and deductions from returned merchandise may have been deducted.
Cost of goods sold is the direct costs associated with producing a company's goods. Cost of goods sold or COGS includes both direct labor costs and any costs of materials such as raw materials used in producing a company's products.
Gross profit measures how effectively a company generates profit from their direct labor and direct materials. Gross profit does not include non-production costs. Only the costs and profit associated with the production facility or factory are included in gross profit. Some of these costs include:
- Direct materials
- Direct labor
- Equipment costs involved in production
- Utilities for the production facility
- Shipping costs
Depreciation and Amortization
As stated earlier, in most cases, depreciation and amortization are treated as separate line items on an income statement. Amortization technically refers to intangible assets, such as a patent. Depreciation is typically used with fixed assets or tangible assets, such as physical property, plant, or equipment.
Below is a portion of the income statement for J.C. Penney Company Inc. (JCP) as of May 5, 2018.
- Total revenue is highlighted in green for the amount of $2.67 billion, while the COGS is beneath revenue, coming in at $1.7 billion.
- Depreciation and amortization of $141 million are listed separately, highlighted in blue below.
- For J.C. Penney, gross profit for the period would include revenue and COGS. Depreciation and amortization would not be used in the gross profit calculation, but instead would be included in operating income, which is further down the statement, totaling $2.66 billion for the period.
The source of the depreciation expense determines whether the expense is allocated between cost of goods sold or operating expense. Some depreciation expenses are included in the cost of goods sold and, therefore, are captured in gross profit.
For example, the depreciation of the building for the corporate office and its furniture would not be included in COGS because it's not a direct cost associated with the production of goods. However, a portion of depreciation on the manufacturer's plant or facility would be included in the overhead costs or fixed costs for the plant. As a result, that portion of depreciation might also be included in the costs of producing the goods or COGS because the depreciation is directly tied to the factory.
It is much more rare to see amortization included as a direct cost of production, although some businesses such as rental operations may include it. Otherwise, amortized expenses are typically not captured in gross profit. Accounting treatment on income statements varies somewhat for each business and by industry.