Gross profit refers to a company’s sales, net of discounts, returns, and allowances, minus the direct costs of selling goods and services.
The composition of direct costs will vary depending on the type of business. Retailing and wholesaling companies, for example, sell inventory in essentially the same form in which they purchased the inventory. The direct costs for a manufacturer or retailer, known as cost of goods sold, or COGS, reflect the purchase price of the inventory units. Some retailers, such as automotive dealers, can identify the specific inventory item being sold and price into COGS the acquisition cost of that item. Most retailers and wholesalers, however, must make an assumption as to which inventory items are being sold. The two most widely used methods for allocating inventory to COGS is the last-in, first-out (LIFO) method and the first-in, first-out (FIFO) method. Under the LIFO method, the company assumes that the most recent inventory purchases are the first sold. Under the FIFO method, the company assumes the oldest purchases are sold first. The choice of LIFO or FIFO accounting can have a significant impact on a company’s gross profit. If prices are rising, the FIFO method will show a higher gross profit than would be shown under the LIFO method. Conversely, if prices are falling, the LIFO method would show a higher gross profit.
Manufacturers purchase raw materials and alter the materials through manufacturing activities. Thus, for manufacturing firms, the direct cost of sales includes allocated labor and overhead, in addition to the acquisition costs of inventory.
Some firms, such as consulting firms, recognize only direct labor in cost of sales.
Another way of looking at gross profit is that it is the amount available to cover the company’s operating expenses.
