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Understanding the difference between gross and net profit

There are major distinctions between gross profit and net profit, and both are equally important figures when it comes to small business accounting. Getting gross profit and net profit confused can have significant consequences, and can make it difficult for you to accurately assess the performance of your business.

What is gross profit?

Gross profit is a metric that represents the income, or profit, that remains after production costs have been subtracted from revenue.

By measuring how much profit remains after the cost of goods sold (COGS) has been subtracted, we’re able to see how well a business is managing production costs and expenses, what processes are working efficiently, and what areas can be improved.

Revenue describes the total amount earned from sales in a particular period. Cost of goods sold can refer to a number of costs involved in producing goods. This typically includes labour costs; material, supply and inventory costs; equipment, repairs, utilities, shipping, and any other cost required specifically in the production and sale of a product or service.

Fixed costs like salary, property and insurance generally don’t count under the cost of goods sold.

How to calculate gross profit

The gross profit formula is very straightforward:

Gross Profit = Revenue - Cost of Goods Sold

You might use net sales figures to determine revenue, especially if you’re a retail business, as net sales accounts for discounts, deductions and refunds. Note that net sales is not the same as net profit/net income. Net sales is simply revenue minus returns, allowances and discounts.

What is net profit?

While gross profit subtracts cost of goods sold, net profit – or net income – includes all of the costs and expenses incurred by a company, subtracted from revenue. The term bottom line typically refers to net income, as it appears at the bottom of an income statement.

Net income subtracts a number of expenses from revenue, typically including operating expenses, loan and debt interest, overheads and administrative expenses, income taxes, and depreciation. Other income sources, like short-term investments, would also be included. Proceeds made from the sale of assets are deemed income too.

You might, for example, pay for an attorney, pay rent for office and factory space, and pay interest on borrowed finance. These are all fixed, recurring costs that are independent of production; you’ll still pay these costs whether you manufacture 50 products in a year or 500. This is unlike the cost of goods sold, which is directly dependent on production and sales.

Net profit subtracts all costs and expenses, and adds all income.

How to calculate net profit

Put simply, the net profit formula is as follows:

Net Profit = Total Revenue - Total Expenses

You’ll have already determined gross profit before calculating net profit. You can break the formula down in further detail as follows:

Net Profit = Gross Profit - Operating Expenses – Additional Expenses – Taxes – Debt Interest + Additional Income

Net profit margin represents the percentage of each dollar earned that ends up as profit at the end of a financial period.

Gross profit vs. net profit

While gross profit is used to examine a business’s ability to earn a profit against its production and labour costs, net profit can provide better insight towards the company’s structure and operations – because gross profit factors in direct costs only while net profit factors in all costs, and all income.

In calculating gross profit, you may identify a weakness in your production process or sales strategy. You may find that you’re spending too much on production without getting much in return, and need to re-strategise your operations to boost your gross profit margin.

Net profit paints a more accurate picture of how a company is performing financially, accounting for fixed costs and extra income that wouldn’t be applied to calculate gross profit. Net profit can help you identify fixed costs that are negatively impacting your bottom line.

Even if gross profit is favourable, other areas of the business may be mismanaged – like debt or loan management – and this is why net profit is an important figure to assess the overall management of a business.

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