Cost of goods sold and operating profit

Here is the idea in a story. A furniture maker starts the year with finished chairs worth ₹5,000 left over from last year (opening stock). During the year he buys wood worth ₹90,000 (purchases) and spends ₹15,000 turning it into chairs (direct expenses). So he had goods worth ₹1,10,000 available to sell. At the year end, chairs worth ₹10,000 are still unsold (closing stock). His net sales were ₹1,50,000.

What did the chairs he sold cost? Not ₹1,10,000: the ₹10,000 of unsold chairs will be sold next year, so they are not this year's cost. The goods sold cost 1,10,000 − 10,000 = ₹1,00,000. That is the cost of goods sold:

Cost of goods sold = Opening stock + Net purchases + Direct expenses − Closing stock. Then Gross profit = Net sales − Cost of goods sold: 1,50,000 − 1,00,000 = ₹50,000. If cost of goods sold is bigger than sales, the result is a gross loss.

Closing stock is usually given outside the trial balance, so it must be brought into the books: Closing Stock A/c Dr, To Trading A/c. It then appears twice: on the credit side of the trading account, and as an asset in the balance sheet. In the book, once Ankit's closing stock of ₹15,000 is included, his gross profit becomes ₹57,000 and his net profit ₹19,500; after ₹500 interest on a loan, ₹19,000.

Operating profit (also called EBIT, earnings before interest and tax) is the profit from the normal running of the business. It leaves out financial items, like interest on loans, and abnormal items, like a loss by fire, a loss on selling furniture or a profit on selling investments.

Operating profit = Net profit + Non-operating expenses − Non-operating incomes. For Ankit: 19,000 + 500 interest = ₹19,500. So the order is: gross profit first, then operating profit, then net profit.