Updated July 7, 2023
Definition of Gross Profit
Gross profit is a measure of the earnings of the company from its core business operations, and the calculation of the same is done by deducting the cost of goods sold and other direct expenses such as power & fuel, freight inward, etc., from the total sales revenue of the business.
Explanation
In every business, it is calculated to measure the company’s earnings from the core business activity, which includes the movement of manufacturing & selling goods. It can sometimes be termed gross margin as a percentage of sales revenue. The business prepares the trading account to calculate the company’s gross profit by directly linking the direct costs, such as raw material purchases, direct labor, carriage inwards, and other costs, to production. The cost of opening stock is deducted from sales revenue and closing stock.
Formula of Gross Profit
The formula is as follows:
Where,
Sales refer to the total turnover of the business for a given period.
- opening inventory cost is the cost of inventory lying unsold with the business at the beginning of the given period & closing inventory cost is the cost of inventory that remains unsold until the end of the given period.
- The cost of raw materials is the purchase cost of raw materials in a given period to be used in production.
- Direct labour is the cost of labour employed in the production, and direct expenses are other expenses apart from raw material costs & labour costs that can be directly attributed to the production of goods.
Examples of Gross Profit
Suppose a company named Toy Inc. has made the following transactions in the financial year ending on March 2020.
- Sales Revenue was $2,000,000
- The total Purchase of raw materials was $1,050,000
- Opening inventory was $210,000
- Closing Inventory was $250,000
- Freight inward was $ 50,000
- Wages paid to factory labor were $150,000
- The salary paid to office staff was $55,000
- Rent Paid for the office was $70,000
We need to calculate the company’s Gross Profits from the above figures.
Solution:
Calculation:
| Particulars | Amount ($) |
| Sales Revenue | 2,000,000 |
| Less: Cost of goods sold | 1,210,000 |
| Gross Profit | 790,000 |
Calculation of Cost of goods sold
| Particulars | Amount ($) |
| Opening Inventory | 210,000 |
| Add: Purchases | 1,050,000 |
| Add: Wages paid to labor | 150,000 |
| Add: Freight Inward | 50,000 |
| Total | 1,460,000 |
| Less: Closing Inventory | 250,000 |
| Cost of goods sold | 1,210,000 |
Therefore, the company’s gross profit is $790,000, and the rent paid for the office and the salary paid to office staff are not taken as a part of COGS as they are not direct expenses.
How to Use It?
Its uses of it are as follows:
- It gives us the data regarding the closing inventory, which the management or the auditor may use for checking purposes with the physical balance lying with them on any date.
- It calculates the company’s gross profit ratio by dividing the gross profits by the net sales multiplied by 100.
- The company’s reasonable internal control of its system may rely on the stock data coming by this method which will ease them out from monthly or quarterly stock-taking resulting in saving time.
- It helps determine the organization’s performance level by comparing the data with the companies or industries in the same line or with its data from previous years.
Advantages
Some of the advantages are as follows:
- It is one of the essential components used for calculating the gross profit margin ratio of the company. In addition, it is a crucial ratio used for comparing production efficiency over the period.
- It is one of the essential measures to know how much percentage of markup the company can take on its sales value.
- The company can use it to measure its efficiency in using its supplies and labor to produce the goods and services.
Disadvantages
Some of the disadvantages are as follows:
- If one compares the company’s yearly gross profits trend, then there are chances that they might get misleading figures when gross profit rises, but the gross profit margin falls. So in such a case, the company should compare using the gross profit margin ratio.
- The company’s profitability cannot be measured solely on gross profits because it doesn’t consider many costs, such as non-operating expenses.
- Its measurement is used to compare the company’s performance with other companies. Still, the analysis will be done within the companies of different industries. It is not the correct measurement as it varies significantly from sector to sector.
Conclusion
It refers to the company’s profit calculated by deducting the cost of goods sold from its total turnover. In the manufacturing and trading industry, we prepare the trading account, which includes sales revenue and closing stock on one side. On the other side, we list all the direct costs, such as raw material costs, labor costs, and other direct expenses, as well as the cost of opening inventory. By deducting the direct costs and opening inventory costs from the total sales and closing stock, we calculate the figure for gross profit. This figure serves as a performance indicator. If the trend of gross profit concerning the previous years or industries in the same line shows an increasing trend, it indicates that the enterprise has the potential to grow.
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