2019-06-21 18:57:05Accountants and Bookkeepers: Accountants and BookkeepersEnglishNet profit is referred to as the bottom line of the income statement. This article deals with what is net profit and why is it important...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2019/06/What-is-Net-Profit.jpghttps://quickbooks.intuit.com/in/resources/accountants-and-bookkeepers-accountants-and-bookkeepers/what-is-net-profit/What is Net Profit?

What is Net Profit?

12 min read

What is Net Profit?

Net Profit is a measure of profitability of a company usually referred to as ‘the bottom line’ of the income statement. It refers to the profit that remains after deducting expenses from gross profit. These expenses include all operating expenses, non-operating expenses, taxes and preferred stock dividends of a business.

Therefore, net profit is an important component of trading and profit and loss account of a business. The trading account represents the results from the manufacturing activities of a business. That is, the activities that involve manufacturing, purchasing and the ones that help in bringing goods to the point of sale. Thus, purchases is one of the constituents of such activities. The other constituents of the activities directly related to the production are direct expenses. These expenses include carriage inwards, freight inwards, wages, factory lighting, coal, water and fuel, royalty on production, etc.

On the other hand, the profit and loss account represents the Gross Profit on the credit side. Furthermore, the expenses related to normal operations of a business are represented on the debit side. These expenses include operating, non-operating and indirect expenses.

Net Profit Example

We considered Wipro’s Annual Report for 2017 – 2018 in our previous article on Gross Profit. The idea was to understand the concept of Gross, Gross Profit formula and important ratios concerning Gross Profit. So let’s consider the annual report once again to understand:

The Net Profit of Wipro Limited for the year ended March 31, 2018 was Rs 80,084 million. This was reasonably less as compared to the previous year’s Net Profit that stood at Rs 85,143 million. Net Profit was calculated as the difference between gross profit earned and expenses incurred at the end of the accounting period. The following table showcases the consolidated financial highlights of Wipro Limited for the year ended March 31, 2018:

Example showing the income statement to explain what is Net Profit

It is clear from the above table that first operating profit is calculated to calculate Net Profit. Then, operating Profit is ascertained as the difference between Gross Profit and sum of following expenses:

  • Selling and Marketing Expenses
  • General and Administrative Expenses
  • Foreign Exchange Losses/Gains
  • Other Operating Income

Then, the following expenses or incomes are adjusted to operating income to calculate Net Profit of Wipro:

  • Finance Expenses
  • Finance and Other Income
  • Income Taxes

Now, all expenses deducted from Gross Profit and Operating Income are indirect expenses. These expenses are not directly related with the manufacturing activity. That is, it is difficult to trace how each of them individually contributes to the production of goods.

Therefore, let’s understand some basic terms associated with the calculation of  Net Profit to understand the concept clearly.

You May Also Read

How to Calculate Gross Profit?

Direct Expenses

These are the expenses that are specifically caused by the product, project, organizational unit or any other purpose for which costs are measured. Thus, direct expenses are the expenses related to the manufacture of a product or rendering of a service linked to the cost object.

A cost object includes a:

  • product
  • service
  • cost center
  • activity
  • sub-activity
  • project
  • contract
  • customer or distribution channel or any other unit in relation to which costs are ascertained.

For instance, cloth used in manufacturing a piece of garment is a direct cost to the batch of garments under manufacture. Furthermore, the wages of the employees working directly in manufacturing the garments are a part of the direct expenditure.

Following are the expenses that are considered direct:

Opening Stock

It is the stock of goods or inventory that is in hand at the beginning of the year. Such a stock is carried forward from the previous year and does not change during the accounting period. This item appears on the debit side of the trading account as it forms part of the cost of goods sold during the year.

Purchases less returns

Goods bought for reselling after adding value are considered purchases. These appear on the debit side of the trading account of your business. Further, these include both cash and credit purchases. On the other hand, goods returned are the goods that are sent back to the supplier. These goods are deducted from the purchases and appear as net purchases in the trading account.

Wages

Wages refer to the earnings of the workers who worked directly on the cost project. It is a remuneration given to the employees engaged in factory for loading, unloading and production of goods. These appear on the debit side of the trading account.

Carriage Inwards/Freight Inwards

These are the transport expenses incurred while bringing raw materials or goods purchased to the place of business. These expenses are borne with regards to the purchases made during the year. Furthermore, these expenses appear on the debit side of the trading account.

Fuel/Water/Power/Gas

These expenses are incurred during the manufacturing process and are hence considered direct.

Packaging Material and Packaging Charges

Packaging charges refer to the cost of the packaging material used in the product. It is a direct expense for your business. This expense is considered direct as the containers or any other packaging material used to contain the goods form a part of the goods to be sold. However, the packing material refers to the containers that are used for transporting the goods. It is regarded as an indirect expense. Such an expense is debited to the profit and loss account of your business.

Indirect Expenses

These are the expenses associated with two or more cost projects jointly. The indirect expenses cannot be traced directly to each of the cost projects. That is, it is not possible to figure out how much of the cost is attributable to a single cost project.

Thus, indirect expenses are the expenses not directly attributable to a particular cost object. These expenses include: Selling and Distribution overheads, Administrative Overheads and other expenses such as finance expenses. And Selling and Distribution Overheads and Distribution Overheads combined together are referred to as Marketing Overheads.

Let’s consider each of them individually

Overheads

Overheads include costs of indirect materials, indirect employees and indirect expenses. These expenses are not directly identifiable to a cost object in an economically feasible manner.

Distribution Overheads

Next, Distribution Overheads are the costs incurred in handling a product or service from the time it is ready for delivery until it reaches the ultimate consumer. For instance, cost of packing, repacking, labeling, etc.is a part of the distribution cost. Following expenses come under distribution cost:

  • Packing, repacking or labeling
  • Transportation cost
  • Cost of warehousing

Selling Overheads

Then, Selling Overheads are the expenses related to the sale of products. These include all Indirect Expenses incurred in managing sales of an organization. Following costs are a part of selling overheads of a business:

  • Salaries of sales personnel
  • Travelling expenses of sales personnel
  • Commission to sales agents
  • Sales and brand promotion expenses including advertisements, publicity, sponsorship, endorsements and similar other expenses.
  • Receivables Collection costs
  • After sales service costs
  • Warranty costs

Administrative Overheads

Administrative Overheads are the costs of all the activities related to the general management and administration of an organization.  These overheads do not include production overheads, marketing overheads and finance costs.

Production Overheads

Production overheads include administration expenses that relate with production, factory, works or manufacturing.

Finance Costs

  • Finance costs are the costs incurred by a business in relation to borrowing funds. These expenses include:Interest and commitment charges on bank borrowings
  • Amortization of discounts or premium related to borrowings
  • Interest and commitment charges on short-term and long-term borrowings
  • Amortization of ancillary costs incurred in connection with the arrangement of borrowings
  • Finance charges in respect of finance leases
  • Exchange differences arising out of foreign current borrowings to the extent they are regarded as an adjustment to the interest costs.

Cost of Sales or Cost of Goods Sold

Cost of goods sold refers to the direct costs incurred to produce goods or render services with the purpose of selling them. These costs include the cost of materials and direct labor costs incurred in producing goods. However, cost of goods sold does not include indirect expenses, like selling and distribution costs. Hence we can say:

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock

Operating Profit

Operating Profit refers to the profit earned through the normal operations and activities of your business. It is the excess of operating revenue over operating expenses. Thus, the Operating Income for the year ended March 31, 2018 stood at Rs 84,294 million. This figure is calculated after considering operating expenses and revenues but before accounting financial incomes and expenses.

Therefore, while calculating operating profit, the income and expenses of a purely financial nature are not taken into account. Hence, we can say that operating profit is profit before interest and tax (EBIT). Similarly, abnormal items such as loss by fire, etc. are also not taken into account while calculating Operating Profit.

Operating Profit of a company is calculated as follows:

Operating profit = Net Profit + Non Operating Expenses – Non Operating Incomes
Or
Operating Profit = Gross Profit – Operating Expenses + Operating Incomes

Net Profit Formula

Let’s try to understand how Net Profit is calculated after having a fair idea about various components of Net Profit, . Generally, the formula for Net Profit stands at:

Net Profit = Gross Profit + Other Incomes – Indirect Expenses

So let’s consider the consolidated Income Statement of Wipro Limited as of March 31, 2018 to understand how Net Profit is calculated.

Consolidated Income Statement of Wipro to explain what is net profit

As it is apparent from the statement above, Gross Profit stands at Rs 155,716 million for the year ended March 31, 2018. This is calculated using the following formula:

Gross Profit = Revenues – Cost of Sales

In calculating Gross Profit, all direct expenses of manufacturing goods are considered in the cost of sales. Once Gross Profit is calculated, the operating income of Wipro is calculated. In calculating operating income, all the expenses incurred or income gained in operating and managing Wipro’s business are deducted from Gross Profit.

The operating expenses include Selling and Marketing Expenses, General and Administrative Expenses and Foreign Exchange Losses. These expenses totaled Rs 76,490 million (42,349 + 34,141) for Wipro for the year ended March 31, 2018. However, Wipro did not have a foreign exchange fluctuation loss. Instead, there was a gain amounting to Rs 1,488 million against foreign exchange. This is operating income for Wipro. Thus, after considering operating expenses and incomes, total operating income for Wipro in the current year was Rs 84,294 million.

Then to calculate net profit, all non-operating expenses and taxes are deducted from and non-operating incomes are added to the operating profit. Thus, the net profit for Wipro for the current year comes to Rs 80,084 million.

Why is Net Profit Important?

How much profit your business generates depends upon the efficiency of its operations. Such levels of profit are determined after considering both long-term and short-term goals of your business. In the short-run, the level of profitability showcases your business’ capability to sustain its operations. Whereas, in the long-run, the pattern of profitability helps in taking managerial decisions such as expansion of business.

Apart from this, even the stakeholders of your business analyse profits generated by your business over a period of time. Each stakeholder examines the level of profitability from a different perspective. For an internal stakeholder like the top management, it is important to analyze profits as it helps them to measure the efficiency of the business. Such information helps the financial expert in guiding the management on its operational aspects.

Similarly, the owners of the business analyze its profitability to measure their return on investment. While the employees are more bothered about their salary, incentives and other fringe benefits. Lastly, the creditors of your business analyze profits to know whether their investment is a safe investment or not.

Net Profit Ratios

The accounting ratios are an important tool in analyzing the financial statements of a business. The profitability ratios, also known as performance ratios, help in determining the earning capacity of your business. These ratios let you know the efficiency with which the resources of your business are utilized.

The important ratios based on Net Profit are Net Profit Ratio and Net Profit Margin.

Net Profit Ratio

Net profit ratio is based on all inclusive concept of profit. This ratio showcases relationship between revenue from business operations and net profit after operational as well as non-operational expenses and incomes. The Net Profit ratio is calculated as under:

Net Profit Ratio = Net profit/Revenue from Operations × 100

Generally, net profit refers to profit after tax (PAT).

This ratio gives you a fair idea about the profitability of your business. Furthermore, it gives insights about the overall efficiency of your business. This is an important measure from the point of view of investors.

Net Margin Ratio

Net profit margin is the amount of profit realized by your organization as a percentage of the total sales generated during an accounting period. The objective of calculating such a ratio is to figure out the earning trends of your business over a period of time. Thus, the Net Margin Ratio is calculated as under:

Net Profit Margin = Net Income/Net Sales (Revenue)

This ratio gives investors a fair idea about the income and expense elements that determine Net Profit Margin of your business. It gives investors an opportunity to have a comprehensive view of the Net Profit margin of your business.

Thus, we can say that Net Profit or the bottom line of your business is the most important number to consider. This measure gives a fair view of the profitability of your business and its financial performance.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Related Articles

What is the Difference Between Gross Profit and Net Profit?

The very reason why you carry out business is to generate profits.…

Read more

What is Gross Profit Formula?

What is Gross Profit? Gross Profit is an item that appears in…

Read more

What is Gross Profit And Why Is It An Important Mesaure?

Gross Profit is one of the most important measures to determine the…

Read more