Gross profit is arrived as the difference between net sales and cost of goods sold. Cost of goods sold is calculated by using the following formula:

Opening inventory + Net purchases + Direct expenses – Closing inventory.

Net profit is arrived at after deducting all operating expenses, interest and taxes from gross profit. Operating expenses are generally incurred in the form of salaries, rental payments, office stationery, telephone and electricity bill, legal fees, travelling expenses, advertisement expenses and so on. These expenses are incurred in relation to day to day functioning of the business and have no relation with the production process. Let us take a simple example to understand the process involved in calculation of gross and net profit.

A Company Has Following Figures For The Year Ending On 31st March 2011:

Opening inventory: Rs. 15,000/-
Purchases: Rs. 2, 00,000/-
Wages paid to labour: Rs. 45,000/-
Carriage inwards: Rs. 30,000/-
Sales: Rs. 6, 00,000/-
Sales returns: Rs. 25,000/-
Advertising: Rs. 30,000/-
Salaries to employees: Rs. 75,000/-
Legal fees: Rs. 15,000/-
Office rent: Rs. 30,000/-
Telephone bill: Rs. 3,000/-
Electricity bill: Rs. 2,500/-
Stationery: Rs. 250/-
Closing inventory: Rs. 35,000/-

Gross Profit As Calculated From Above Figures Would Be:

Net sales: 6, 00,000 (Sales) – 25,000 (Sales returns) = 5, 75,000
Cost of goods sold: 15,000 (Opening inventory) + 2, 00,000 (Purchases) + 45,000 (Wages) + 30,000 (Carriage inwards) – 35,000 (Closing inventory) = 2, 55,000
Gross profit: 5, 75,000 – 2, 55,000 = 3, 20,000

Net Profit As Calculated From Above Figures Would Be:

3, 20,000 (Gross profit) – 30,000 (Advertising) – 75,000 (Salaries) – 15,000 (Legal fees) – 30,000 (Office rent) – 3,000 (Telephone bill) – 2,500 (Electricity bill) – 250 (Stationery) = 1, 64,250

Gross profit indicates the efficiency with which a company’s manages its production process, that is, effective use of raw material and utilization of labour. A higher gross profit indicates that company will have more money to manage its day to day operations. If there is an increase in raw material or excess labour is required for same volume of sales, gross profit is bound to decline. Similarly if there is a decrease in sales, while cost of production remains at the same level, gross profit figure will not be in company’s favour. There can be no fixed figure or percentage for gross profit. Gross profit can vary from industry to industry and from company to company.

Net profit indicates a firm’s competitive position in the market. It is the net income which a company gets after meeting all of its costs including taxes. Businesses with higher net profit have better chances of survival in the long run. Companies with lower net profits in relation to their sales can face problems to the extent of closure. Even when a company’s gross profit is high, no control over operating expenses can result in severe crisis. In the above example, gross profit margin stands at 55.65% of the net sales whereas net profit stands at 28.56% of net sales.

Now if operating expenses increase by 50% of what they are currently, net profit would come down to Rs. 86,375/- representing 15% of net sales. Again net profit can also vary from industry to industry and from company to company.Gross Profit and Net Profit are important measures from a company’s stand point. Even though it is possible to make a comparison between the two, each margin has its own importance in evaluation of performance.

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