Understanding Accounting Profit Formula

In mathematical terms, profit is defined as 'the difference between the cost price and the selling price of a product where the selling price is greater than the cost price'.

But in the bigger picture where business and investments are involved, account profit is best described as the surplus amount which remains after settling all the expenses incurred in the business growth and development.

Accounting profit does not include opportunity costs which is included in calculation of economic profits. If we consider areas of business, when there is a surplus earned on the amount that includes the secondary costs, the profit is termed as gross profit.

Hence, accounting profit is the difference between income received and payable expenses within the defined accounting period.

Before we understand about how to calculate the formula for accounting profit, there are some terminologies that need to be understood.

Capital amount (CA) = Assets (Fixed + Current) - Liabilities (Current + Long term)

This capital amount is inclusive of the profit earned sans the drawings/expenses incurred from the capital. Now the calculation is done on basis of accruals or matching concept.

The gross profit earned on a capital precisely includes all the costs which includes the amount indebted to trade creditors. The accruals or matching concept ensures that the expenses incurred in the profit calculated to earn the profit should match.

Say, for instance, you have 10 pencils and sold 8 of them. So you cannot make a profit and loss account with the cost of all 10 pencils when you still have 2 in stock. If you do not follow this concept in business, the accounting profit earned will be lower than it actually would be.

So net profit/accounting profit is calculated as:

Accounting profit = Gross Profit (Gross sales/revenue) - Expenses incurred in earned gross profits (Operational + Miscellaneous costs).

Gross profit, which is reported on upper portion of income statement in balance sheets, is calculated by deducting the cost of sold products from the total sales revenue. The sales revenue also includes purchase discounts, and interest generated from investments.

The second profit that follows up is the operational profit which can be calculated by deducting operational expenses from gross profit. Operational expenses include commissions, advertising expenses, hourly wages, equipment maintenance charges and freight loading charges.

Net profit or the accounting profit forms the last section of the income statement. This is calculated by deducting all the operational and sundry expenses from the gross profit. This accounting profit is however taxable. So the income statement has two entries: Net profit before tax deduction and net profit after tax deduction.

The accounting profit percentage is calculated by dividing the gross sales revenue by the net profit amount. Understanding the relationship between the accounting profit and the gross revenue will aid in increasing the profitability margin of an organization.

There are many accounting software that will help in calculation of accounting profits thereby help businessmen analyze their profits. Accounting profits earned, many a time, are also included as a part of retained earnings calculation (if the profits are earned in surplus) to promote business growth and development.