What is Gross Profit?
Gross Profit is an item that appears in the Trading and P&L Account of a company. It is the difference between net sales revenue and cost of sales of a business. Here, the net sales revenue refers to the total revenue less the cost of sales returns, allowances and discounts. Whereas, the cost of sales refers to all the costs incurred to create a product or a service.
Thus, we can say that Gross Profit is the profit generated as a result of conducting basic operational activities in a business. These basic operational activities include manufacturing, purchasing and selling of goods.
Gross Profit Formula
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 formula equation:
Gross Profit = Sales – Cost of Goods Sold = Sales – (Opening Stock + Purchases + Direct Expenses – Closing Stock)
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How To Calculate Gross Profit ?
The relevance of calculating Gross Profit is to know whether the selling of goods or rendering of services to the customers has turned out to be profitable for your business or not. Purchases is one of the main components of expenses incurred while running your business. Besides purchases, there are other expenses that your business bears. These expenses are divided into direct and indirect expenses.
The direct expenses are the expenses that directly relate with the production activity of your business. These include expenses related to the manufacture, purchase of goods and activities that help in bringing the goods to the point of sale. Such expenses include:
- Carriage Inwards
- Freight Inwards
- Factory Lighting
- Water and Fuel
- Royalty on Production
Now, the sum of purchases and direct expenses is referred to as cost of sales.
Similarly, sales is another important component of your business. And the excess of sales over the sum of purchases and direct expenses is termed as Gross Profit. However, if the cost of sales of your company exceed the sales revenue, then what you get in return is Gross Loss.
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 goods shipped or services rendered during an accounting period. Such sales do not include taxes like GST generally charged to your customer. This is because such taxes are the collections your business makes from the customers on behalf of the government. Moreover, these taxes are a liability to the government unless they are paid. Similarly items like freight and postage are also not included in the Gross Sales. This is because such items are expenses and are not revenues.
Sales Return and Allowances
Sales Return refer to the sales value of goods returned by your customers. And allowances are the grants that you give to the customers. Such allowances are given on account of goods being defective or for some other reason. There are two ways to show sale returns and allowances:
- Subtract Sales Return and Allowances directly from sales or
- Show amount of sales returns and allowances separately
However, it is wise to show it separately as it clearly represents various constituents.
Sales discounts refer to the amount of discounts taken by the customers in lieu of prompt payment. These are also referred to as cash discounts.
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 Example
As mentioned above, Gross Profit is the excess of sales over cost of sales. 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 we can say that in most cases, the business shall have opening stock as well as closing stock every year. However, the formula to calculate cost of goods sold should be worked as per the following equation:
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock