Question

( Unit 5 Discussion Word has gotten around that you know accounting and can explain it well. Jim, another of your friends has a unique business. During the summer he buys hats that cost $5.00 each and sells them at the beach for $12.00 each. Other than the cost of the hat, his only other expense last summer was $120 for parking. He sold 78 hats last summer. His accountant prepared a financial statement for him and he has several questions about the income statement. He asks: 1. What does the cost of goods sold and gross profit mean? 2. How much gross profit do I make on each hat? 3. Why show both gross profit and net income? If I have hats returned or a give a discount, how will that be shown on the income statement?

Answer 1

Answer. To Understand each question properly, have a very careful look on the Income Statement presented as follows.

Income Statement

	$
Sales Revenue- (78 units $\times$ $12)	936
Less: Cost of Goods Sold:-(78 units $\times$ $5)	390
Gross Profit	546
Less: Packing Expense	120
Net Income	$426

Answer (1). Cost of Goods sold meant the price paid for purchase of hat, including transportation and any freight expenses or custom and duty paid if any.

Gross Profit is the excess of Sale Revenue over the cost of goods sold in terms of dollar value. This can be presented in the form of equation, i.e, Gross Profit = Sales Revenue - Cost of Goods Sold. The Sales value of goods sold is $936 and Cost of goods sold is $390, thus having Gross Income of $546.

2) Gross Profit per Hat = Gross Profit $\div$ No. of hat sold = $546 $\div$ 78 = $7. So, Gross Profit made per hat is $7 (12-5).

3) Gross Profit is shows direct revenue and direct expense relating to purchase and sale of goods. Where as Net income is shown to show the net profitability of the business. Net income is arrived after deducting operating expenses indirectly related with sales of goods and service. Net income is residual that is distributed among stockholders. Generally Gross profit margin is higher than net profit margin.

4) If there was sales return, it would have been deducted from sale revenue to arrive at net sales that would have been also shown in income statement. If there was discount allowed, it would have been also deducted from Gross Profit, along with packing expenses to arrive at net profit. Such expense reduces the net income.