Knowing the difference between gross profit and net profit matters for 2 main reasons:
And that’s because it records the difference between your sales and what is costs you directly to make those sales. That difference represents your sales margin or markup. It is the first indicator of profitability in a business.
A while back I was watching an episode of Dragons Den (called Shark Tank in the USA) that reminded me of the confusion that abounds around the words: turnover, gross profit, net profit, profit margin, EBITDA and a bunch of other terms that have everything to do with how you view the profitability of a business.
Contestants on that show almost always fail when they get their numbers wrong (or worse – they don’t know what they mean). But luckily it’s easy. Read on…
This is your total sales figure. Literally, in money terms, how much you sold during a particular period (usually your financial year). Add up every bit of money that comes into the business with the exception of Sales Tax/VAT, loans, sale of capital items, and interest received and that is your turnover.
The reason loans, capital items and other money is not included is because they are usually not a core part of a business. So whatever it is a business sells as a normal part of its trading activities represents its turnover.
Turnover To Date means the turnover so far this financial year. From this you can start to make a prediction of your total turnover for the year. For example, if you’re 9 months into your year and your turnover to date is 75,000, then you can predict with some degree of certainty that your total turnover for the year will be 100,000.
If you have professional indemnity insurance you will need to have an idea of your forecast turnover for the current year. Most policies allow a degree of error of 50% (to make up for the uncertainty factor), but check your insurance small print.
Never confuse turnover with profit. Always quote turnover excluding VAT (or Sales Tax in the USA). If you quote turnover including tax, any potential investors will run a mile (they will see you as someone who likes to inflate figures). Sales Tax and VAT is not your money (you are just collecting it on behalf of the government) so it should never be included.
If all you sell is a service. And there are no costs directly involved in supplying that service, then your gross profit is the same as your turnover.
However, if you resell goods or services, manufacture things for resale or have costs directly involved with selling what you do, then you need to remove those costs from your sales in order to arrive at your gross profit.
Typically these costs will be held in an account called Cost of Goods Sold (aka COGS). If you sell mainly services, this is often shortened to simply Cost of Sales (COS).
Here’s a simple example: You buy a widget at a cost of 100 and you resell it for 200. If you sell just one of these, your turnover will be 200. However, your gross profit will be 100 (because you must subtract the cost of the goods sold).
Other direct costs include shipping or postal costs (as these will not be incurred if nothing is sold). They will also include packaging of those goods, and if you manufacture them yourself, all the costs involved in that process (we know they are direct because unless you manufacture them, you won’t have anything to sell, plus everything you manufacture is for resale).
Compare this to the costs of renting your office and heating and lighting it. You have to pay all those costs whether or not you sell a thing. These costs are termed overhead costs. Salaries and wages are also part of your overhead so are not included in your gross profit calculation. These items are included later to determine your net profit (see below).
Gross margin measures the gap between what it cost you to produce a product (or buy it for resale) and how much you got for it when you sold it.
Using the previous example, the gross margin is 50%. Gross Margin = (Selling Price less Cost Price) divided by Selling Price multiplied by 100.
As another example, if you sold a product for 200 which cost you 160 to buy or manufacture, your gross margin would be 20%. Here’s the filled in gross margin equation of that last example: (200 – 160) / 200 x 100 = 20
Like gross profit, knowing your gross margin is vital. And that means knowing with a good deal of accuracy your cost of goods or cost of sales. If you don’t know what it costs you to buy, manufacture and ship something, then you cannot set a price that you know will return a profit (and this is why so many contestants in Dragon’s Den and Shark Tank get eaten alive!).
Markup is another way of talking about margin. If you buy a product for 100 and you resell it for 200, you have marked it up 100%. If you bought something for 100 and wanted to mark it up by 25%, the selling price would be 125.
Most retailers operate on a markup of at least 100%. The exception is for commodities where the competition is usually so fierce, everyone is forced to compete on price.
Certain luxury goods also have the same problem, but in a different way. For example, Apple sell both online and in retail stores. They fix their own prices and ensure those prices remain high everywhere by selling on goods to other retailers with only a small discount. Note that price fixing in any other way (eg. trying to force your resellers to sell at a certain price) is illegal in most countries.
Be warned. There are multiple versions of Net Profit. The bottom line is your turnover less all costs. Your costs are not only Cogs and overheads but also depreciation of your assets, any amortisation of loans and just as importantly the tax liability on any profit made.
Accountants use different abbreviations to show exactly what degree of profit they are reporting. The most common is EBITDA.
EBITDA is an acronym for Earnings Before Interest, Taxation, Depreciation and Amortisation. In other words your turnover less COGS, overheads and other expenses. EBITDA is the most common way to report Net Profit.
You can quote on any subset of this. For example: EBIT = Earnings Before Interest and Taxation (so here we are including depreciation and amortisation).
Learn the above and you will impress any investor (and bank manager).
NOTE: Find out more about profit, loss and other accounting and bookkeeping jargon with our free Definitive Guide to Bookkeeping belowContinue With The Definitive Guide To Bookkeeping Here
Depreciation is the amount an asset has reduced depending on age, wear and tear, and current market value. It is a core part of bookkeeping, and usually applied at year end (for larger businesses it is often calculated every month as part of management reporting).
When you record the purchase of an asset such as equipment or buildings for use in a business, you place it in the Fixed Asset section of your Chart of Accounts. Whenever you look at this section, you can see at a glance how much your assets originally cost.
However, in order to account correctly for your business, you need to record the change in value of those assets. This can be because the item is no longer new, and is therefore worth less than originally paid. It can also be due to wear and tear or damage.
On top of that, an asset could also be stolen, exchanged for another or simply sold. All of this needs recording.
It can be recorded directly in the asset’s account itself, so a check on the transactions and the balance in that account will show its original value followed by its reduction in value over the years, or, more usually, a separate account will be opened to record those changes. This extra account is called an Accumulated Depreciation account (because the amount the asset reduces by over time is added together to give a total balance).
This continues until the Asset’s account its corresponding depreciation account cancel each other out. Whilst the asset still has a value, we can look at the two accounts together to show the current value of the asset.
Usually, assets are classified into general groups (eg. Office Equipment, Motor Vehicles) to keep the number of accounts as small as necessary to accommodate reporting requirements for both the Inland Revenue and management.
Strictly, any asset should be valued at its actual market price when the depreciation needs to be reported. In reality, that can often be hard to do, so there are a few conventional ways to make this easier. The two most used forms of depreciation are:
Straight line means reducing the asset by a fixed value until the asset balance is zero. For example, at 25% per year, it will take 4 years to reduce the asset to zero. This is the most common way to depreciate assets.
A reducing balance means the asset never gets to zero. Using the same 25% rate, the reduction is applied to the last known value. So if an asset starts at 400, then after 1 year at 25% it will be worth 300. At this point it is the same as the Straight Line method. However, in year 2, it will be 25% of 300 (slightly less than 100 taken in year 1).
The reducing balance method is more accurate since it could be argued that whilst you still have the asset it will always have a value, however small.
Depreciation is a bookkeeping exercise. It has nothing to do with tax liability. Instead inland revenue services around the world offer tax benefits, an example of which is Capital Allowances (UK). You can choose to take the allowance or not depending on whether you have made a profit. That means the allowance will often be completely out of kilter with the book value.
From a business perspective, it is the book value that is important. It tells the business owner how much it would cost to replace those assets should it become necessary to do so.
There are 3 main sections in any set of books for any business. They are:
Assets is where we store the value of all equipment, vehicles or other purchases of substantial value that we intend to use in the business. Assets represent the things the business owns. Some of those things may be items we buy with the intention of selling them for a profit. This is our stock (also known as inventory). However, those are not the assets we use to report depreciation on.
Whilst they too (stock bought fo resale) decrease in value if they’re not sold, they are accounted for in a slight different way, which will be covered in another article.
What we’re interested in right now are those things the business buys that will last longer than 1 year and that are used either in the business, or to add value to the business.
Office Equipment is the most common, since this is one thing every business (that has an office) is likely to buy – even if it’s on hire purchase or lease-buy type contracts.
If the business is the legal owner of that equipment (regardless of whether it has been paid of in full) then it will be recorded on the balance sheet as an asset, and it will also have a separate account created for it that shows by how much its value has decreased since it was purchased.
In other words we will be using 2 accounts in our bookkeeping system to record its total current value. For something like office equipment, these are usually called:
When we purchase office equipment we credit the bank (assuming that’s how we paid for it) and we debit Office Equipment. If we value of our equipment was, say, 1000, then the balance of the Office Equipment account at that point in time would be 1000.
If we decided to depreciate office equipment using the straight line method by 25%, we would add a new transaction crediting Office Equipment Depreciation by 250 (1000 x 25%).
Since every credit must be balanced by a debit, the other side of this double entry would be a debit to Office Equipment Depreciation Expense. This will affect our profitability, which is what we want – the company has in effect lost 250 of its value during that period of time, which is now reflected in the P&L account.
To get the current value of our asset we add the balances of the 2 accounts together: 1000 – 250 = 750. We are saying that the value of that office equipment (were we to try to sell it at the time we depreciated it) would be 750. This is typically done at the end of each financial year.
In year 2, we would add the same depreciation transactions, and so the combined balances of the 2 accounts would drop to 500. In year 3 the balance would be 250. And in year 4 it would be zero.
That fall is also recorded in the profit and loss account as explained, which ultimately ends up in the Equity section of our balance sheet. The equity section represents what the business owes its owners, so if you’re following along, you can see how that happens from the entries we have been making.
In reality that never happens because we will very likely have bought more office equipment in the meantime. Plus any equipment that has depreciated to zero (ie. that has been on the books for 4 or more years) will either have been thrown or given away, or sold.
The last thing we need to do to complete an asset that has no value in the books is to remove its original cost from, in this example, the Office Equipment account, and its total depreciation in the Office Equipment Depreciation account. We do that by crediting Office Equipment for the assets full value and debiting Office Equipment Depreciation by the same amount.
If an asset is sold, and the price we got for it is worth more than the book value (the ‘book value’ is literally the total balance in our books of the asset using those 2 accounts introduced earlier) then we must also report a gain. We have in effect made a profit on the sale of our assets. So that gain will be recorded in our profit and loss account under a new account named something like: “Gain On Sale Of Assets”.
If we sold it at a loss, it would also be recorded in the profit and loss account, but this time in an account named something like: “Loss On Disposal Of Assets”.
The other side of this transaction will debit the account that received the money from the sale (eg. a bank account).
And once that was done, we would then Credit Office Equipment and Debit Office Equipment Depreciation to zero out the value of the original asset and its total depreciation (leaving the rest of the Office Equipment assets and depreciation as they are to reflect the current values).
Suppose we bought an asset for 1000 with cash, depreciated it at the end of the year 1 by 250, and then sold it for 750 for cash. Since the value of the asset at the end of year 1 was 750, and we sold it at that point for 750, no loss or gain has been made. Here’s all the transactions you would have made to account for everything including the original purchase:
If these were the only transactions in our bookkeeping system, we would have the following final balances in our 4 accounts:
Since the -250 cancels the +250 we know the books balance. And that is how it always must be.
In the UK and most countries in the world, you cannot claim capital purchases as a direct expense of the business. This is simply because assets like these usually last more than a year (so you still have the asset and it’s still worth something, so you cannot write its full value off against tax – that’s what it all boils down to – does the thing you bought still have some value and do you still own it at year end).
However, as it depreciates in value over time, you must still record that in your books – as explained above, and it would be wrong that you could not claim that depreciation against tax. But rather than doing the obvious – which is just to respect its value in the profit and loss account, governments over the years have chosen to make it a special case.
And so with a special case you need a special tax, and in the UK its called a Capital Allowance. None of this is recorded in your books. It’s purely a tax thing, not a business value. As a result, if you make a loss one year, you won’t want to claim the depreciation against tax – you can do that next year instead if you make a profit. Because of this discrepancy, your books can show one value for your assets, and the Inland Revenue another.
In the USA different names are used. As it’s also complicated, take a look at the Wikipedia entry for it here.
If you want to know more about depreciation and capital allowances, join the Accounting for Everyone online bookkeeping course today:Find Out More…
Depreciation is really important yet few bother to do it. Why? because it seems so hard to do.
But the reality is that it is really very simple.
But first we need to look at what it is, and why we need to do it.
Everything you buy to use for your business is an asset. However, over time your assets generally lose value. A computer becomes obsolete, your vehicle’s mileage gets higher and higher and requires more and more spare parts. Something that you bought today, may be cheaper to buy a year from now.
There are many reasons of course. So why do we need to record the change in value to our assets? It is because we must always reflect a true picture of our business.
We may need to do that in order to get a loan, or to show our investors the value of the business as it stands today, or to value the business properly if we are going to sell it.
There is one more important thing about depreciation. It is a book value item. That is, it has NOTHING whatsoever to do with tax and limiting your liability for it. This is a common misconception.
Inland Revenue services around the world deal with asset depreciation and claiming that depreciation against tax in different ways, but the most common is by giving business owners an allowance.
When you record depreciation, you are doing so only in your books. Never ever think of depreciation as some form of allowance or tax mitigating transaction. You are simply recording what you (or some valuer) really believes the loss (or gain) in value of an asset really is.
This is a good thing. You want your books to reflect reality. In fact you are legally obliged to do so. Before we get into the transactions, here’s one last reason why you must see depreciation and allowances as different things.
In many countries, if a business makes a loss, they can put off an allowance and carry it forward to a future year. So you can get the case where a business has bought, say, a computer for 500 and values it at the end of the year at 300 (if you bought a brand new computer today, how much could you sell it for tomorrow?).
The depreciation on that computer is 40% and that is what you must record in your books (don’t worry the actual transactions are coming shortly). However, your Inland Revenue (IR) service may only let your claim a 25% allowance, so you can see that the balances will already be skewed. But that is how it should be.
A worse case is where you make a loss and decide not to claim that year. In your books the computer will be worth 300 but your IR service will still have it valued at 500. The following year you will depreciate it down to, say, 200 and because you make a profit you will want to claim your 25% allowance of… 500! which is 125.
So now your book value is 200 and the IR have it as 375. The bottom line is, unless you are a tax specialist or you are submitting your own tax returns, you need not be concerned with the IR valuation. You are only concerned with recording a true and fair picture of the value of your business.
Your chart of accounts should be set up with a group called ‘Fixed Assets’. This is where you add accounts to hold the balance of assets you have bought. Each asset account should have a depreciation account associated with it. This will hold the accumulated depreciation of assets over the years (it is often called ‘Accumulated Depreciation’ for this reason).
To see the value of your assets, subtract the accumulated depreciation from the asset balance.
The reason for keeping both balances is so that you can see at a glance what your assets originally cost you (in case you need to replace them so you get a better idea of the investment needed).
There is one thing missing from this though. Where do we record the other side of the Accumulated Depreciation amount?
The answer is in the Profit and Loss account. You can set up a new group in there specially for it. Let’s call the account This Year’s Depreciation (or even P&L Depreciation to make it clear where it is going).
So make a journal Debiting This Year’s Depreciation and Crediting Accumulated Depreciation.
That’s it. That’s all there is to it.
Using the technique taught in the Accounting for Everyone course, you are simple transferring an amount From Accumulated Depreciation To P&L Depreciation.
If you want to try this out, download the trial of Business Accountz available on Accountz.com and give it a go. Use the Green books (‘transfers’) to do this or use the traditional journal. Remember you can flip between From/To and Credit/Debit in the menu option Tools > Language (choose English – Accountant for the latter).
And if you haven’t done so already, sign up below to start the Accounting for Everyone Online Certified Bookkeeping Course. We go into depreciation in greater detail on the course, including standard ways to depreciate such as straight line depreciation and reducing balance.[ez_box title=”Start The Certified Accounting for Everyone Online Bookkeeping Course Today” color=”orange”]Instant access to the whole course plus online certification plus 150 page downloadable workbook with answers [ez_btn color=”grey” url=”https://legendary.simplero.com/page/3887-accounting-for-everyone-fast-track” target=”_self”]£29.99[/ez_btn][/ez_box]