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Cost of sales and gross profit

Understanding accounts series

Introduction

In many ways this is one of the more important factsheets in our library, because most businesses that buy things and sell them on need to measure gross profit very carefully.

The trading and profit and loss account

Perhaps not the title you were expecting! The reality is that the full and correct title of that particular statement used to be the trading and profit and loss account. The word trading is the clue here and for many businesses such as one person consultancy businesses, there is no trading as such. Trading is defined on the web as:
1. the act or process of buying, selling, or exchanging commodities, at either wholesale or retail, within a country or between countries: domestic trade; foreign trade. 2. a purchase or sale; business deal or transaction. 3. an exchange of items, usually without payment of money. 4. any occupation pursued as a business or livelihood. Courtesy of dictionary.com (http://dictionary.reference.com/browse/trading)
For practical purposes we can forget number three, and number four is more generic, describing self-employment. After sales in the trading and profit and loss account comes a group of expenses called cost of sales. These are the costs that are incurred by the business to make the sales happen. So they are going to include the costs of materials, packaging, production wages and other costs falling into the same generic group. One of the bases used in preparing accounts is to match income and expenditure for the time period covered by the accounts and so cost of sales should measure exactly the costs of producing the sales in the accounts. Cost of sales doesn’t include everything purchased during the year as there may be stock left over not yet used, there may be products partly completed and there may be finished items not yet sold. These amounts are included in a stock adjustment called closing stock. Let’s say that you make flat-packed bookcases. Every similar bookcase is going to take the same amount of wood, packaging, wages etc. These costs are known as direct costs and always include the costs of producing what you sell. So for every bookcase you sell, it costs you £20 and you sell it for £50. It follows then that if you sell 100 bookcases, your direct costs will be 100 x £20. The costs are proportional to the sales and we can use this relationship to help us measure our business performance.
Sales100 x £50=£5000
Cost of sales100 x £20=£2000
The difference between sales and cost of sales is called
gross profit100 x £30=£3000
If you tried to understand whether or not your gross profit was better or worse than expected by looking only at the financial number, you would struggle somewhat.

So how do we understand gross profit?

The easiest way is to translate the numbers above into percentages, so let's take another look at the example above:
Sales100 x £50=£5000100%
Cost of sales100 x £20=£200040% (2000 divided by 5000)
Gross profit100 x £30=£300060% (3000 divided by 5000)
So if in a particular year your accounts look like this:
TargetActual
Sales100 x £50=£5000100%£4800100%
Cost of sales100 x £20=£200040%195040.6%
Gross profit100 x £30=£300060%£285059.4%
We've got some questions to ask. Admittedly the differences shown are not substantial and probably “just” some small issues creeping in, but even small issues are best dealt with early. So what could have gone wrong? Sales are less than £5000. We can’t tell from this set of accounts how many items were sold. If it was 96, then all is well. If not, then how many? We need to know the answer to this before we can go any further. Let’s say it was actually 100. That means that the average sale price of each was £48 instead of £50. Why? Market pressures? So if we sold 100 items, that means the average cost of each one was £19.50, which is £0.50 less than expected. So what happened here? Were the workers more efficient? Did you manage to do a deal on materials that got you a better price? Did you find some kind of materials efficiency? Gross profit % is also known as gross margin. Things get more complicated if you have more than one product and each one makes different gross margin. You then need to consider the mix of each product when you are deciding on your targets and it makes understanding changes in your margin a tad more difficult. The gross margin also may be translated as pence per £1 of sales. In the above example, the business aims to make 60p in the £1.

How do I know if my gross profit is “right”?

This is a question I am often asked. The answer I usually give is that it depends on how much profit you add on to the cost. Certainly there are common numbers – many retailers aim to make 60-70%, garages often 30-40% – but it really does depend on you. The important thing, having decided how much profit you want to add on, is to measure it. And if you need help with that we can show you a number of different ways you can do this. Be careful, however, about what you mean by profit. Many businesses when starting from cost to work out selling price add on what they call profit. If you do this by using a percentage then that is not the same as your gross profit %. Let me explain:

Markup or margin?

Using our earlier example, the cost is £20 and we want to sell for £50 so we need to mark up from cost by adding on £30. To do this in one calculation and find out what your mark up is: Divide your selling price by the cost of sales: Sales: £50 Divided by Cost of sales £20 = 2.5 And the markup is 2.5-1 = 1.5 (or 150%) Mathematically, the gross margin is 1 – (1/ Markup + 1) in our example, 1-(1/1.5+1) = .6 or 60%

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic. No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers. Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant. Return to Advice page.