Profit is nothing but the surplus of revenues over expenses of a business over a given period of time. It is a key component that drives every business. Thus, the ultimate aim of any business enterprise is to generate profit. Further, each business unit must earn sufficient profits in order to sustain and grow over a long period of time.
However, profit is an absolute term. Profit alone does not help much in determining your business’ efficiency at a particular period. A very high amount of profit earned by your business does not always mean that your business is efficient. Similarly, lower profit do not necessarily indicate the financial sickness of your business. So, as an enterprise, it is important for you to know how much profit your business is generating relative to:
- the resources invested and
- revenue generated using such resources.
This is termed as profitability. Most of the times, both profit and profitability are used interchangeably. However, both the terms have a different purpose. Profits indicate excess revenues over expenses. But, profits alone do not reveal anything about the operational efficiency of your business. Thus, you need to undertake profitability analysis to measure:
- the return on capital invested and
- operational efficiency of your business.
Therefore, you need to use certain profitability ratios to undertake profitability analysis. Gross Profit Ratio, also known as Gross Profit Margin is one of the important ratios used for analyzing profitability.
So let us first understand what is Gross Profit before determining how to calculate gross profit.
What is Gross Profit?
Gross Profit is one of the components of profit and loss statement of your business. It is the difference between net sales and cost of goods sold. In other words, it is the profit generated as an outcome of undertaking the basic operational activities of your business. Such basic activities include:
- Purchasing and
- Selling of Goods
Why is Gross Profit Important As A Measure?
To determine the operational efficiency and financial performance of a business, it is important to consider Gross Profit. Gross Profit indicates the ability of a business in making use of its available resources including raw material, labor and other supplies.
There can be a variety of reasons due to which the Gross Profit of a business gets affected. These could include:
- Improvisation in the existing products leading to higher prices
- Efficient management resulting in lower cost of sales
- Changes in accounting policies that result in shifting expenses from cost of sales to overheads and vice-versa
- Buying raw materials at lower cost as a result of a new vendor or vertical integration of businessSo, to understand the concept of Gross Profit and its importance, let’s consider an example.
Emerson – Manufacturer of High Efficiency Heat Pumps
Eemrson is a technology and engineering company providing solutions to industrial, commercial and consumer markets worldwide. The company generated a Gross Profit of $6.4 billion in 2017 and $6.3 billion in 2016. Furthermore, Gross Profit Margin for the year 2017 was 42%. This reflected a reduction of 1.2 percentage points over 2016. Such a decline was on account of acquisition of Pentair Valves and Controls business.
The result of such an acquisition lead to acquisition accounting charges related to inventory and a slightly lower price. However, the cost reduction actions of the company helped in offsetting the decrease in revenues to a certain extent.
Thus, when analyzing the profitability and financial performance of an entity, it is important to consider Gross Profit. This is because it demonstrates the efficiency of the business in making use of its labor, raw material and other supplies.
Now there are a variety of reasons that can impact the Gross Profit of your business. This change can be due to:
- Changes brought about in the products that lead to charging high prices
- Efficiency in managing the business that results in low cost of sales
- Certain changes brought about in few of the accounting policies that lead to moving expenses from cost of sales to overheads or vice versa
- Purchasing raw materials at a low cost as a result of vertical integration of business
How To Calculate Gross Profit?
As mentioned above, Gross Profit is an important component in financial analysis to determine the operational efficiency of the business. Gross Profit is used against sales to understand if the goods sold or the services rendered to the customers are profitable or not.
Now, various expenses are incurred in order to run a business. Purchases is one of the major expenses that a business has to incur. Likewise, there are other expenses that a business has to bear in order to undertake the various business activities. These expenses are bifurcated into direct and indirect expenses.
Direct expenses are the ones that are directly related to the production activity of your business. These constitute expenses related to:
- manufacturing and purchasing of goods and
- activities that help in making goods ready for sale.
- Freight Inwards
- Factory Lighting
- Carriage Inwards
- Royalty on Production
- Water and Fuel
Now, cost of goods sold is nothing but the sum of purchases and direct expenses. Furthermore, sales are also an important part of your business. Thus, Gross Profit is arrived at by deducting the cost of goods sold from sales. However, if the cost of sales of your business is in excess of sales revenue, it results in Gross Loss for your business.
Thus, the formula for calculating Gross Profit is as follows:
Gross Profit = Sales – (Purchases + Direct Expenses)
Now, there are times when a company may choose to report separate items in the sales revenue section of the income statement. The following statement showcases how to calculate net sales using such items:
Gross Sales refers to the invoice value of the goods shipped or services rendered during an accounting period. These do not include taxes like GST generally charged to your customer. This is because such taxes are the collections that your business makes from the customer on behalf of the government. Moreover, unpaid taxes are a liability for the government. Similarly, Gross Sales do not include items like freight and postage. This is because these are expenses and not revenues.
Sales Return and Allowances
Sales Return refer to the sales value of goods returned by your customers. And allowances are the grants you give to the customers on account of goods being defective or for some other reason. The amount against Sales Return and Allowances can be either subtracted directly from sales or can be shown separately. However, it is wise to show it separately as it clearly represents the various constituents.
Sales discounts, also called cash discounts refer to the amount of discounts taken by the customers in lieu of prompt payment.
Net Sales Formula
Hence, as shown above, to calculate net sales, we need to follow the following net sales formula:
Net Sales = Gross Sales – Returns and Allowances – Sales Discount
Now, there are expenses that are not directly related with the manufacturing activity of your business. These are referred to as indirect expenses. So while preparing profit and loss statement, all such expenses are moved to the debit side of the statement. Whereas, the revenues or gains other than the sales of your company are moved to the credit side of the profit and loss statement.
If the credit side of the profit and loss statement exceeds the debit side, then the difference is the net profit of your business. In case, the debit side of the profit and loss statement exceeds the debit side, then what you get in return is the net loss.
Net Profit = Gross Profit + Other Incomes – Indirect Expenses
The Net profit/loss so calculated is transferred to the balance sheet, which is a capital account.
Gross Profit Formula
As mentioned above, Gross Profit is the excess of sales over cost of sales. That it is the difference between total sales and the sum of purchases and direct expenses. Following is the gross profit equation:
Gross Profit = Sales – (Purchases + Direct Expenses)
Thus, to understand how is gross profit calculated, the gross profit formula can be explained with the help of the following example.
Following is the Trading and P&L Account of M/s Verma Traders:
Gross Profit Analysis
Now, by looking at the profit and loss statement above, it is clear that the Gross Profit just represents the basic operational activity of M/s Verma Traders. The same comes out to Rs 42,000. Apart from the Gross Profit, M/s Verma Traders earns a commission of Rs 5,000 and has incurred expenses or losses worth Rs 42,500 (25,000 + 13,000 + 4,500 + 4,500). These expenses or losses include salaries, rent and bad debt. Thus, the net profit that is the excess of the credit side over the debit side of the profit and loss account turns out to be Rs 4,500.
Cost of Goods Sold
Now, in the example above, there is no opening stock and closing stock. The cost of goods sold only includes purchases made and direct expenses incurred by M/s Verma Traders on its manufacturing activity during the year. Notice that purchases amounted to Rs 75,000 and the wages stood at Rs 8,000. Therefore, the cost of goods sold was calculated as:
Cost of Goods Sold = Purchases + Direct Expenses
= Rs 75,000 + Rs 8,000
= Rs 83,000
Since, there is no unsold stock at M/s Verma Traders during the end of the year, therefore it is assumed that whatever stock was purchased was sold during the year. But if we see on a general level, there is always some stock left at the end of the accounting period.
Therefore, to explain the concept of cost of goods sold, let’s assume that M/s Verma Traders was not able to sell all the goods. Infact out of the total goods purchased, it was only able to sell goods worth Rs 60,000 during the year. In this case, M/s Verma Traders will have an unsold stock of goods costing Rs 15,000. This stock in hand is referred to as closing stock. Hence, the cost of goods sold shall be calculated in the following manner:
Cost of Goods Sold = Purchases + Direct Expenses – Closing Stock
= Rs 75,000 + Rs 8,000 – Rs 15,000
As a consequence, since there exists closing stock at M/s Verma Traders during the end of the accounting period, this will change Gross Profit. That is, the Gross Profit figure turns out to be worth Rs 57,000 as against Rs 42,000 as in the previous case.
The following table shows the calculation of the new Gross Profit:
Now, the closing stock worth Rs 15,000 is transferred to the balance sheet. And this closing stock acts as the opening stock for the next year. Furthermore, the closing stock shall be sold during the year. Thus, in most cases, business shall have opening stock as well as closing stock every year. Hence, to calculate cost of goods sold, use the following equation:
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock