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Profit costs represent the cost of items in relation to a company’s sales. Costs may be direct or indirect. Direct costs usually include raw materials, production labor and manufacturing overhead. Indirect costs include selling, general and administrative expenses made during a specific time period. Indirect profit costs often relate to the nonessential services a company uses when producing goods. All companies have some type of cost associated with their profit generating activities. Manufacturing and production companies often have the highest amount of direct profit costs.
Profit costs are usually listed on a company’s income statement. The income statement includes revenues, cost of goods sold, and expenses for an accounting period. Cost of goods sold is the more common term for a company’s direct profit costs. Most companies prepare income statements on a monthly basis. Quarterly and annual income statements are quite common in larger or publicly held companies. Two important numbers are calculated from the information on a company’s income statement: gross profit and net profit.
Gross profit represents the difference between a company’s sales revenue and cost of goods sold. This calculation gives business owners and managers a dollar figure indicating how much money was generated from product sales. Business owners and managers can also use the gross profit ratio to create a benchmark for this dollar figure. The gross profit ratio is sales revenue minus cost of goods sold divided by cost of goods sold. The resulting percentage is a benchmark companies compare to a competing company or the industry standard. Business owners use the gross profit percentage to compare their information to a company who may not have similar business operations.
Companies also use the net profit ratio to calculate their income profitability after all direct and indirect profit costs are subtracted from sales. The net profit ratio is net profit divided by net sales. Net profit is the bottom line from a company’s income statement. Net sales is total revenue sales less any returns, discounts or allowances to consumers. The net profit ratio provides business owners with a percentage similar to gross profit ratio. The net profit percentage indicates how much money the company can expect to make on revenue sales after deducting cost of goods sold and monthly expenses.
Business owners often use the gross profit and net profit ratios to determine if a reduction in direct or indirect profit costs is possible. Comparing these benchmarks to the industry standard provides managers with a valuable performance analysis tool. Business owners and managers can also create a historical trend of profit percentage benchmarks to compare previous accounting periods to the current accounting period. This analysis allows companies to focus on why they may be earning less money from current business operations.