Which one of the following denotes Gross Profit ?

Correct — B, (b) Sales less Cost of goods sold. Gross profit is the first of the two profit figures a trading business reports, and it measures one thing only: the margin between what goods were sold for and what those same goods cost to bring to a saleable state. It is the balancing figure of the Trading Account, and the definition is exactly the option's words — net sales minus the cost of goods sold. The work in the definition sits inside the second term. Cost of goods sold is not the purchases figure; it is opening stock plus net purchases plus direct expenses, less closing stock — the adjustment that strips out goods bought but not yet sold and brings in goods sold out of last year's stock. Direct expenses here are the costs of getting the goods ready for sale, such as carriage inwards, freight, octroi, import duty, wages and factory power. Because gross profit stops at that line, indirect expenses — salaries, rent, advertising, depreciation, interest — do not touch it; they are charged in the Profit and Loss Account afterwards to arrive at net profit. That is the whole architecture: sales less cost of goods sold gives gross profit, and gross profit less indirect expenses plus other incomes gives net profit.

Why the others are wrong

• (a)Cost of goods sold + Opening stock — This adds two costs to each other and never mentions revenue, so it cannot produce a profit of any kind — every profit figure in accounting is a revenue minus a cost. It is doubly wrong because opening stock is already inside cost of goods sold: cost of goods sold is opening stock plus purchases plus direct expenses less closing stock, so adding opening stock again counts the same figure twice. Note that this is the only option printed with an arithmetic plus sign; the other three spell the operation out as the word 'less', and that difference in printing is a fair signal that this one is doing something different from the rest.
• (c)Sales less Purchases — The near-miss, and the option that catches a candidate who knows the shape of the answer but not the second term. Sales less purchases equals gross profit only in the special case where there is no opening stock, no closing stock and no direct expenses — that is, where purchases happen to equal the cost of goods sold. In any real trading account they differ: unsold goods at the year end have been purchased but not sold, and last year's stock is sold this year without being purchased this year. Purchases is a transaction total; cost of goods sold is a cost matched to the sales of the period.
• (d)Net profit less Expenses of the period — This runs the ladder backwards. Net profit is what is left after the period's indirect expenses have already been taken out of gross profit, so subtracting those expenses a second time drives the figure further down rather than back up. To move from net profit to gross profit a candidate would have to add the indirect expenses back and remove any other incomes credited to the Profit and Loss Account. The option is a useful reminder that the two profit figures come in a fixed order — gross first, net second — and that each stage removes a different class of cost.

Final accounts of a trading business separate profit into two stages, and the separation is the point. The Trading Account takes net sales on the credit side and, on the debit side, opening stock, net purchases and direct expenses, with closing stock brought in on the credit side; its balancing figure is gross profit if the credit side is larger and gross loss if it is not. The Profit and Loss Account then starts with that gross profit, adds other incomes such as commission, discount received and rent received, and charges the indirect expenses — office and administrative, selling and distribution, and financial — to arrive at net profit, which is what goes to the capital account or to reserves. Keeping the two apart is what makes the accounts diagnostic: a falling gross profit ratio points at pricing, purchase cost or stock loss, while a healthy gross margin with a weak net profit points at overheads. The same split explains why cost of goods sold must be computed rather than taken from a ledger. There is no ledger account called cost of goods sold in a periodic inventory system; it is derived as opening stock plus net purchases plus direct expenses less closing stock, and the closing stock adjustment is the single most common place for an examiner to plant an error. Net purchases themselves are purchases less purchase returns, and net sales are sales less sales returns, so both terms in the gross profit definition are net figures.

Key facts

• Gross profit = Net sales − Cost of goods sold; it is the balancing figure of the Trading Account.
• Cost of goods sold = Opening stock + Net purchases + Direct expenses − Closing stock.
• Net sales = Sales − Sales returns; Net purchases = Purchases − Purchase returns.
• Direct expenses are the costs of bringing goods to a saleable condition — carriage inwards, freight, octroi, import duty, wages, factory power and fuel.
• Net profit = Gross profit + Other incomes − Indirect expenses; indirect expenses never enter the Trading Account.
• Gross profit ratio = Gross profit ÷ Net sales × 100, and it is the standard test of trading margin.
• Gross profit may be quoted either as a percentage on sales or as a percentage on cost, and the two are not interchangeable — a margin of 25 per cent on cost is 20 per cent on sales.
• If the debit side of the Trading Account exceeds the credit side, the balancing figure is a gross loss, which is carried to the debit of the Profit and Loss Account.

Common traps

• Treating purchases as the cost of goods sold. They coincide only when there is no opening stock, no closing stock and no direct expenses.
• Charging indirect expenses to the Trading Account. Salaries, rent, advertising and depreciation belong to the Profit and Loss Account.
• Forgetting to net off returns. Both terms in the gross profit identity use net figures.
• Confusing a rate on cost with a rate on sales when a question gives a gross profit percentage.
• Assuming the profit ladder can be climbed in either direction. Net profit is derived from gross profit by deducting; the reverse move adds back.

• practice — not a real PYQ

  Opening stock is ₹ 40,000, purchases ₹ 2,00,000, direct expenses ₹ 10,000, closing stock ₹ 50,000 and sales ₹ 3,00,000. What is the amount of gross profit ?

  • (a)₹ 90,000
  • (b)₹ 1,00,000
  • (c)₹ 1,10,000
  • (d)₹ 1,50,000

  Answer(b) ₹ 1,00,000

• practice — not a real PYQ

  The excess of the credit side over the debit side of the Trading Account is called :

  • (a)Net profit
  • (b)Gross profit
  • (c)Operating profit
  • (d)Surplus

  Answer(b) Gross profit