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Financial Reports: How to Read the Income Statement for Gross Profit

The Gross profit line item in the income statement's revenue section is simply a financial reporting calculation of net revenue or net sales minus the cost of goods sold. Basically, this number shows the difference between what a company pays for its inventory and the price at which it sells this inventory.

This summary number tells you how much profit the company makes selling its products before deducting the expenses of its operation. If the company shows no profit or not enough profit here, it's not worth being in business.

Managers, investors, and other interested parties closely watch the trend of a company's gross profit because it indicates the effectiveness of the company's purchasing and pricing policies. Analysts frequently use this number not only to gauge how well a company manages its product costs internally, but also to gauge how well the firm manages its product costs compared with other companies in the same business.

If profit is too low, a company can do one of two things: find a way to increase sales revenue or find a way to reduce the cost of the goods it's selling.

To increase sales revenue, the company can raise or lower prices to increase the amount of money it's bringing in. Raising the prices of its product brings in more revenue if the same number of items is sold, but it may bring in less revenue if the price hike turns away customers and fewer items are sold.

Lowering prices to bring in more revenue may sound strange to you, but if a company determines that a price is too high and is discouraging buyers, doing so may increase its volume of sales and, therefore, its gross margin. This scenario is especially true if the company has a lot of fixed costs (such as manufacturing facilities, equipment, and labor) that it isn't using to full capacity.

The firm can use its manufacturing facilities more effectively and efficiently if it has the capability to produce more product without a significant increase in the variable costs (such as raw materials or other factors, like overtime).

A company can also consider using cost-control possibilities for manufacturing or purchasing if its gross profit is too low. The company may find a more efficient way to make the product, or it may negotiate a better contract for raw materials to reduce those costs. If the company purchases finished products for sale, it may be able to negotiate better contract terms to reduce its purchasing costs.

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