Q.What will be the effect of purchase of goods for cash ₹ 3,000 on Gross Profit Ratio ?
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Start your 14-day free trial to unlock the full solution →Purchasing goods for cash ₹3,000 increases both the Cost of Goods Sold and the denominator (Sales) of the Gross Profit Ratio, but because the transaction is recorded at cost, the Gross Profit Ratio remains unchanged.
The Concept: Why This Transaction is Neutral
The Gross Profit Ratio is calculated as:
Gross Profit Ratio = (Gross Profit / Net Sales) × 100
Gross Profit itself is Net Sales minus Cost of Goods Sold. So the ratio depends on the relationship between sales revenue and the cost of that revenue.
When you purchase goods for cash ₹3,000, you are simply acquiring inventory. This transaction has two immediate effects:
- Cash decreases by ₹3,000 (asset side)
- Inventory (stock) increases by ₹3,000 (asset side)
No sale has occurred yet. The goods are sitting in your store, waiting to be sold. Until they are sold, neither Sales nor Cost of Goods Sold is affected.
The Accounting Treatment
The journal entry for this transaction is:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Purchases A/c Dr. | 3,000 | |||
| To Cash A/c | 3,000 | |||
| (Being goods purchased for cash) |
This entry increases the Purchases account (which later becomes part of Cost of Goods Sold) and decreases Cash. But note: Purchases is not Cost of Goods Sold. Cost of Goods Sold is calculated only when goods are actually sold, using the formula:
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
Until the goods are sold, they remain in Closing Stock. So the ₹3,000 purchase increases both Purchases and (eventually) Closing Stock by the same amount, leaving Cost of Goods Sold unchanged.
The Critical Point: When the Goods Are Sold
Now, what happens when these goods are eventually sold? Suppose the firm sells them for ₹5,000 (making a gross profit of ₹2,000). The journal entry would be:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Cash A/c Dr. | 5,000 | |||
| To Sales A/c | 5,000 | |||
| (Being goods sold for cash) |
And the Cost of Goods Sold entry:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Cost of Goods Sold A/c Dr. | 3,000 | |||
| To Inventory A/c | 3,000 | |||
| (Being cost of goods sold recorded) |
Notice: The Gross Profit on this specific transaction is ₹5,000 – ₹3,000 = ₹2,000. The Gross Profit Ratio on this transaction alone is (2,000/5,000) × 100 = 40%.
But here's the key: the Gross Profit Ratio is a measure of the overall profitability of sales, not of individual purchases. The purchase itself does not change the ratio because:
- The purchase price (₹3,000) becomes part of Cost of Goods Sold only when sold
- The selling price (₹5,000) becomes part of Sales only when sold
- The ratio depends on the markup the firm applies, not on the purchase cost alone
A common mistake is to think that purchasing goods at a lower cost improves the Gross Profit Ratio. While a lower purchase cost can improve the ratio if selling prices remain unchanged, the act of purchasing itself does not change the ratio. The ratio changes only when goods are sold at a different margin.
The Mathematical Proof …
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