Accounting Principles – Gross Profit

Gross profit on sales forms the subject of considerable discussion in accounting. It is obtained by deducting the cost of sales from the income from sales. It is the first, or prime, profit obtained by placing against the income derived from sales the cost of the goods themselves.

It does not take into consideration the expense of selling the goods, the expense of administering the business, nor any expense in connection with the obtaining or employment of capital. The discussion which arises in connection with gross profit is whether or not it should be shown in relation to cost or to the sales price. It is quite common for one to hear the expression, “The gross profit is sixty per cent.” It is not clear, however, when such a statement is made, whether this percentage is ratio of gross profit to cost or ratio of gross profit to sales. A careful analysis of the question fails to reveal any specific advantage other than a desire for uniformity in either method of treatment. It has been claimed that the ratio should be based on cost, because of the fact that the volume of sales is liable to fluctuate widely. This reason appears fallacious, because of the fact that if sales fluctuate cost should fluctuate accordingly. That either basis is correct so long as it is consistent would appear to be true. As an illustration, let it be supposed that the sales price is $ 1,000, the cost $600, and the gross profit $400. It will then be true that the gross profit is 66 2-3 per cent. of the cost and 40 per cent. of the selling price. If this one case be multiplied by the great number of transactions which might be expected to enter into the accounts of a large concern during the period of a year it will then be seen that if this transaction is a typical one gross profits for the year should be about 66 2-3 per cent. of cost, or 40 per cent. of sales. It would seem to be immaterial which basis were selected. Statistics become valuable only when they can be compared. In the case under discussion at present the comparison would be either with an organization engaged in a similar line of business or a comparison of the figures for this period with those of another period. It would not be consistent to compare the ratio of gross profits in the case of organization A, if this gross profit were based on cost, with the gross profit of organization B, the gross profit of which was based on sales. Nor would it be consistent to compare the gross profit of this period, when based on cost, with the gross profit of the next period when based on sales. The basis would seem to be entirely a matter of a simple arithmetical calculation. Two and two will make four; three and one will make four. The ratio which either one of the component parts bears to the whole will change in accordance with changes in the component parts. Two is 50 per cent. of four; one is 25 per cent. of four; while two is 100 per cent. of two, and one is 50 per cent. of two. If four changes to five, or even six, the relation of two and one, respectively,”to either five or six will change. If the sales increase and the cost remains constant, the ratio of gross profits to sales will increase. If sales decrease, and the cost remains fixed, the ratio of gross profits to sales will decrease. This situation, however, is largely theoretical, because when sales increase or decrease they are usually attended by a corresponding increase or decrease in the cost. The reverse would usually be true. If cost increases or decreases, it should be due to increase or decrease in sales. The percentage of gross profits, whether determined on cost or sales basis, should not be affected fundamentally by fluctuations in either cost or sales.

Some time ago a trade journal published an article by a representative of one of the largest manufacturing concerns in the country. The article occupied four columns of space. It was based on the following question: “A certain article cost $1.00 wholesale. What will it have to be sold for to allow a profit of 10 per cent. after allowing 22 per cent. for cost of doing business?” It was said to be a very simple question, and one that every retailer has to answer in his own business every day, but that seven hundred and fifty out of one thousand retailers answered it wrong. One thousand retailers would probably have answered the question correctly if it had been a fair one. It is a slight reflection on the intelligence of seven hundred and fifty retailers that they were not sharp enough to ask the question, “Is the profit of 10 per cent. on sales or on cost?” and it would appear to be merely a coincidence that two hundred and fifty oat of the one thousand arbitrarily selected the sales basis. It is not at all improbable that the whole proposition was an advertising scheme, simply to involve retailers in discussion and attract attention to the concern which propounded the question. It serves here, however, to illustrate the importance which attaches to the subject. The only objection that the author knows to using the sales basis is that the transaction will never show 1oo per cent. profit. Just as soon as the elements of cost and expense are introduced into a sale it becomes impossible to make 1oo per cent. of profit on the sale. Frankly, this does not seem to constitute a consistent objection to this method. The cost method seems the more logical, however, since the ordinary merchant, in fixing a price upon his goods, begins with their prime cost, and adds the expense of selling them and the expense of administration, etc. To all of these he then adds the percentage of profit which he desires to realize, and such figures constitute his selling price. Cost necessarily precedes selling price. Hence it would seem illogical for a man to settle upon a selling price and then deduct the profit which he desires to make, in order to ascertain what his cost is to be.
The percentage of gross profit is undoubtedly a valuable means of presenting comprehensive information as to profits. A certain line of goods showing a gross profit of 60 per cent. for the present year should, under precisely similar conditions, show the same percentage of gross profit during the next year. If the gross profit is different, then the cause must be sought in one of two places—sales or cost. If the sales have increased during this period as compared with the next preceding, whereas the cost has remained practically the same, the cause of the increase in profits may be traced either to lower purchase prices or a greater number of completed sales without returns or allowances. This indicates good judgment and efficiency on the part of both the purchasing and sales departments. If the sales have decreased while the cost remains constant the reverse might be true. Sales remaining the same, with costs either increasing or decreasing, might mean lack of initiative or ability on the part of the sales force with either an increase or decrease in the efficiency of the purchasing and manufacturing departments, in accordance with either the increase or decrease in the cost of the goods.

Statistics of this nature are not conclusive. They are merely indicative. Without them the situations such as have just been described would, perhaps, never be thought of. They are expedients which are inexpensive and at the same time valuable. They are made use of very largely by organizations constructed on a departmental basis, for judging the capacity and ability of heads of departments. They give clues, so to speak, which may be investigated, and point the way to information which may be of real value to the administrative force. The author remembers one case in which an expedient growing out of suspicions aroused by decreasing gross profits was resorted to to apprehend a bartender who was suspected of failing to account for all the liquor which he dispensed over the bar and instead putting a part of the proceeds into his own pocket. Acting on the suspicion, a series of tests were made to determine approximately what the gross profit on the various kinds of liquors should be. It was ascertained that a bottle of whiskey contained approximately so many drinks, which could be sold for fifteen cents each. The sale price of a bottle of whiskey was, therefore, ascertained. It was known what the whiskey cost. Thus it became possible to determine the gross profit and the ratio of gross profit to cost. Similar tests were made with beer, fancy drinks and bottled goods. These being used as a basis for judging the entire sales of the bar, when the usual calculations for the subsequent month showed the cost of sales respectively, it was an easy matter to apply the respective percentages of gross profit and ascertain the approximate amount of sales for the month. When the sales reported and accounted for fell far short of this amount the management had little hesitancy in charging the bartender with the irregularity, which he admitted.

The establishment of inventories by the gross profit method is frequently resorted to in the settlement of fire losses. Suppose, for example, that a fire occurs at some time other than that at which the inventory has just been taken. Unless detail stock records have been kept and preserved the amount of stock on hand at the time of the fire must be approximated. Sales records will in most cases be intact because of having been put away in the safe. From such records or the sales account in the general ledger or both the sales since the last physical inventory may be established. The application of the average gross profit for three or five years next preceding the fire will give a fair approximation of the cost of the goods sold since the last inventory. With this information available a fairly accurate estimate of the inventory at the time of the fire may be obtained. Normally, inventory at the beginning of the period, plus purchases,—less inventory at the end—equals cost of goods sold. From this it follows logically then, that the inventory at the beginning of the period plus the purchases—less the cost of the goods sold—equals the inventory at the end of the period, which in the case in question means the date of the fire. Such is the manner, making due allowance for the goods in process, in which the estimated value of the stock is arrived at and becomes the basis for fixing the amount of the loss.

Turnover is a term sometimes applied to the cost of sales. It is a term which has come into use in connection with accounting, and constitutes one of the many technical expressions which might better be avoided. When one uses the expression “cost of sales” every one understands what is meant. When one uses the expression “turn-over,” a discussion usually arises as to whether cost of sales or something else is meant. Mr. R. H. Montgomery, C.P.A., in his book on “Auditing,” suggests the following definition, in which the author concurs: “The turnover of a merchant or manufacturer represents the number of times his capital, in the form of stock in trade, is reinvested in stock in trade during a given period.” Mr. Montgomery gives the following formula for ascertaining the turn-over: “Take the starting discovery, add the purchases or cost of manufactured goods, and deduct the inventory at the end. Divide the total by the starting inventory. The result will be the number of times the capital invested in stock in trade has been turned over during the period.”

It will be seen that this expedient may also be used to gauge the efficiency of heads of departments in a concern such as a department store. The number of times which the stock has been turned over will indicate the efficiency of the sales force.

In a large retail shoe store in New York City, which is organized on a departmental basis, the turn-over is ascertained monthly with regard to each department and is useful in administering the business. If the goods in a given department have not been turned over as many times as they should have, an inquiry is made to determine the cause. Failure may be due to a falling off in the demand for the goods offered by that particular department, or by failure of clerks to satisfy the requirements of customers. A little attention is then given to the department in question, with a view to ascertaining the specific cause. If the trouble is found to rest with the clerks, the inefficient clerks are eliminated. A practical application of the turn-over is best seen in organizations similar to the one just mentioned, where the operations can be localized and circumscribed in departments.

The margin of profit on merchandise frequently depends upon the number of times it may be turned over. Almost everyone in New York City is familiar with candy at a “penny a pound profit.” A penny a pound would represent an insignificant profit if it were not for the great number of pounds sold. No doubt if one were to ask of this manufacturer how he can afford to do business on this basis he would reply “because I am able to turn my money over so quickly.” The goods are sold for cash and the profit realized as soon as the goods are sold.

A merchant with a stock of $10,000 which he sells at a profit of 2% will, if he sells such a quantity and value of merchandise six times in the course of a year, be at the end of the year in the same position with regard to profits as the man who sells $20,000 worth of merchandise at 6%. Each will have made a profit of $1,200. Calculate the position of the respective merchants if each is obliged to borrow his entire capital at 4%. The first one will realize a net profit of $800 while the second realizes a net profit of $400.
The suggestion of interest raises a question which might properly accur to one giving thought to the subject. “Is the turnover dependent upon the realization of profit in the form of cash?” In answer it may be said that it is not. Profit is the difference between the cost and selling price of goods and may appear as vested in cash, accounts or notes receivable, etc. When the goods have been sold or turned over the profit arises even though not collected. If goods are sold on credit, it is to be presumed that they may be purchased on credit and on terms equivalent to those on which they are sold. If necessary to borrow funds with which to finance the transaction, the expense of interest will serve to decrease the amount of profit. Such a situation must not be overlooked by the administration in planning the financial operations, but it should not be permitted to cloud the principal issue with regard to the turnover.

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