Gross profit is what the business earns on the goods it sells, before running costs. Net profit is what remains after every running expense and any other income.
This lesson is part of financial statements of a sole trader.
What is the order of calculation?
- Cost of sales = opening stock + purchases − closing stock.
- Gross profit = sales − cost of sales.
- Net profit = gross profit + other income − running expenses.
Gross profit is worked out in the trading account. Net profit is worked out in the profit and loss statement, which starts from gross profit.
Worked example: a fictional shop
An original year, in RM.
| Item | Amount |
|---|---|
| Sales | 48 000 |
| Opening stock | 6 000 |
| Purchases | 30 000 |
| Closing stock | 8 000 |
| Rent | 4 800 |
| Wages | 7 200 |
| Electricity | 1 500 |
| Discount received | 400 |
Trading account. Cost of sales = 6 000 + 30 000 − 8 000 = 28 000. Gross profit = 48 000 − 28 000 = 20 000.
Profit and loss statement. Start with gross profit 20 000. Add discount received 400 to get 20 400.
Expenses are 4 800 + 7 200 + 1 500 = 13 500. Net profit = 20 400 − 13 500 = 6 900.
The shop earned 20 000 from its trading, but 13 100 was used by running costs after the discount. That leaves 6 900 for the owner.
The mistake that costs marks
The slip is to subtract expenses from sales first, or to put running expenses inside the trading account. Both give a confusing “gross profit” that examiners cannot follow.
| Step | Wrong | Right |
|---|---|---|
| Order | Sales − rent − wages − purchases | Sales − cost of sales, then expenses |
| Gross profit | 48 000 − 4 800 − 7 200 − 28 000 = 8 000 | 20 000 |
| Net profit | Reported as 8 000 (missing items) | 6 900 |
A second frequent slip is to deduct drawings as an expense. Drawings belongs in the capital section of the statement of financial position.
Check yourself
Sales are 72 000 and cost of sales is 45 000. Wages are 12 500, rent 6 000 and depreciation 2 500. Interest received is 1 000.
The owner’s drawings are 4 000. Find gross profit and net profit.
Answer
Gross profit = 72 000 − 45 000 = 27 000.
Expenses = 12 500 + 6 000 + 2 500 = 21 000. Net profit = 27 000 + 1 000 − 21 000 = 7 000.
Drawings of 4 000 does not change net profit. It reduces capital in the statement of financial position.
What to study next
Practise the layout in the sole trader practice set, and follow profit into the statement of financial position in preparing a statement of financial position. The cash-profit timeline shows why profit and cash differ.
If you want a teacher to watch you build the statements, see online one-to-one Accounting tuition.