Gross profit is defined as net sales minus cost of goods sold. Net sales is defined as gross sales minus discounts, allowances and returns. Cost of goods sold, or COGS, includes direct labour and raw material costs, but excludes overhead costs. When gross profit is high, it could mean that revenue is high, COGS is low, or a combination of the two.
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When gross profit is high, it may mean that your business is successful in driving sales growth. It may mean that customers feel good about economic conditions and are not deferring purchasing decisions; or that your product mix and prices offer a better value than others; or that demand is so strong that you don't have to do too much discounting.
Cost of Goods Sold
Cost of goods may be lower when the gross profit is high. COGS includes both labour and raw material costs. You may have gone through staff reductions or plant closures that have lowered your direct labour costs. New equipment and redesigned business processes may have led to productivity improvements so that your workers are producing more units at lower costs. Raw material prices may be lower due to more supply coming into the market. Falling energy prices may also be lowering your costs.
High gross profit may mean that economic conditions are generally good. Demand outpaces supply in a growing economy. This usually leads to pricing power, meaning you can raise prices without losing sales. This drives sales growth. As the economy grows, factories that may have been idled during a recession turn their assembly lines back on. This leads to more supply gradually coming back into the market, which keeps costs low. If growth is too robust, raw material and labour prices may rise, which may lead to higher COGS and eventually lower gross profit. Note that gross profits can also be high during a downturn. If sales stay flat, falling raw materials and labour costs could, at least in the short-term, lead to higher gross profits.
Operating profit is gross profit minus overhead (selling, general and administrative expenses). For operating profit to track gross profit higher, overhead expenses must not rise. For example, if you have launched a marketing campaign to drive sales, you may generate higher sales and possible higher gross profit, but it could also lead to lower operating profits since selling expenses will rise.
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