Understanding the differences between gross profit vs. net profit can benefit both businesses looking to make better day-to-day decisions and owners who want to improve their long-term prospects (and profitability). Profit (or lack of profit) is one of the most common metrics that companies use when thinking about new purchases or ways to cut costs.
Though gross and net profit are important in helping owners understand their company’s financial health, they also tell us two very different things. In this article for business owners, we’ll explain what each metric is, what the numbers mean, and how they can lead to smarter decisions.
What does gross profit help you understand about your business?
Simply put, gross profit is the amount of total revenue that you have earned after subtracting your cost of goods sold (or COGS). The cost of goods sold includes all of the direct expenses or investments that are involved in producing a product before it reaches the market. For example, it could be costs associated with labor or spending on equipment or raw materials that make it possible to bring a product to fruition.
Remember that gross profit is calculated to help you better understand your production costs alone, which is especially useful if your cost of goods sold suddenly rises due to increased supplier or vendor costs.
Furthermore, gross profit is the most basic measurement of profit and a metric that gives you greater insight into your business (and core operations); not only does it provide a bird’s-eye view of how much it costs to make your products, but it also helps you understand if they are being priced in a way that makes achieving any revenue goals a realistic target (or if you need to rethink pricing strategies). The gross profit calculation only includes two total metrics, which include:
- Cost of goods sold
Let’s take a look at an example of how this can play out for an entrepreneur named Jane, who owns a small company that manufactures picture frames. When Jane wants to know if she’s efficiently managing her production costs, she can calculate her gross profit to get a clearer picture of what she’s spending to manufacture her product. If she discovers that her gross profit is too low, she can put an action plan together to become more efficient, which might include reducing or streamlining labor, replacing slow machinery, or changing suppliers.
Next, let’s talk about the basics of what net profit is.
What does net profit help you understand about your business?
Net profit, also known as net income, is another metric used to determine how much total revenue you’ve earned after deducting all operating expenses, such as taxes and interest, as well as the cost of goods sold.
Though gross profit can be helpful in telling you how much money you earn from making your products or offering your services, net profit tells you how much money your business earns overall. Net profit is an especially important metric that business owners keep a close watch on because it’s usually a reliable indicator of whether or not a company can to turn a profit.
When you’re calculating net profit, you need to subtract all expenses, including COGS, along with operating costs such:
- Payroll, utilities
- Depreciation and amortization
- Interest expense as well as taxes.
If your total operating expenses exceed your net profit, you’ll have a net loss.
For small business owners, understanding your gross profit and your net profit is a “must-know” because:
- Knowing gross profit helps you view production costs and profitability,
- Net profit allows you to determine whether operating costs need to be trimmed.
Is one of your goals to attract outside investment? Keep in mind that investors, in particular, are interested in both numbers because it allows them to view how efficient product production is for your business as well as how much profit is earned after all expenses have been taken into consideration. It’s also worth mentioning that a company can have a good gross profit and still have a net loss if operating expenses exceed revenue.
There can be a lot to keep track of, so before we get into calculating each metric, the table below can help you stay on top of the main differences.
|Things to know
||Gross Profit||Net Profit|
|Definition||Gross profit is the revenue from sales minus the cost of goods sold (COGS)||Net profit is the total revenue minus all expenses, including COGS and operating expenses|
|What it’s used for||Helps determine the profitability of a company’s core business operations||Measures a company’s overall profitability after all expenses are taken into account|
|Formula||Gross profit = Revenue – Cost of goods sold (COGS)||Net profit = Total revenue – Total expenses|
Let’s talk next about how to figure out how each number comes together.
How do you calculate gross profit?
All the information you need to calculate both gross profit and net profit are found on your income statement, including your cost of goods sold, or COGS. Cost of goods sold is the cost of all items required to produce your product and generally includes the following expenses:
- Direct materials such as raw materials
- Direct labor costs for production workers
- Equipment costs for equipment used in direct labor
- Repair and maintenance costs for equipment
- Utilities for production facility
- Shipping costs
Calculating gross profit is a fairly straightforward math equation: you’ll deduct your total cost of goods sold from the total number of sales you record. Here’s how the equation looks:
Sales revenue (minus) – Cost of goods sold = (equals) Gross profit
Let’s check in on Jane’s manufacturing company, where revenue for the month of October was $51,000, while COGS came in at $17,000. To calculate her gross profit, Jane would subtract the COGS total from her revenue. Let’s put the formula to work:
$51,000 (Revenue) – $17,000 (COGS) = $34,000
The result? Jane’s gross profit for October ends up at $34,000.
Things seem to be looking up for Jane’s framing company, but we still need to factor net profit into the equation.
How do you calculate net profit?
From all indications, Jane’s production costs seem reasonable when taking a closer look at her total gross profit. But to see how profitable Jane’s company really is overall, you’ll also have to calculate her business’s net profit, and we’ll do this next, using the following formula:
Gross profit (minus) – Operating expenses (minus) – interest, and taxes = (equals) net profit
Operating expenses cover all costs that you incur during the course of doing business, including the following:
- Rent or mortgage payment
- Employee wages & taxes
- Supply expenses
- Marketing & advertising
You’ll also need to include any interest expense or taxes that have been paid.
Jane has the following expenses for the month of October:
- Rent – $1,500
- Utilities – $1,250
- Office supplies – $95
- Employee wages – $13,000
- Employee taxes – $1,150
- Advertising and marketing – $250
- Total Operating Expenses – $17,245
Jane had no interest expense, but did have taxes in the amount of $350 (so we’ll add those to our calculation below). Now, Jane is ready to crunch the numbers and calculate her net profit:
$34,000 – $17,245 – $350 = $16,405
Now let’s see how this information would look on the books by taking a peek at Jane’s income statement for the month of October.
October 31, 2022
|Cost of Goods Sold||$17,000|
|Advertising and marketing||$250|
|Total operating expenses||$17,245|
|Income/Loss Before Taxes||$16,755|
Bottom line: Get an understanding of gross vs. net profit
Though it may take some getting used to, as a small business owner, keeping track of all the calculations and formulas that impact your bottom line is time well-spent. The key takeaway is that understanding how numbers like gross profit and net profit work (and how they fit into a company’s financial well-being), can be a good idea for up-and-coming entrepreneurs as well as seasoned professionals with decades of experience. By having a grasp on both concepts, you’ll likely manage your business goals more efficiently and gain a deeper understanding of how operating costs shape planning.
Good luck as you continue moving forward with your business goals and using the insights gained from gross vs net profit to get you there.