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Did you know that inaccurate financial reporting can lead to a company collapse? Even minor inconsistencies can lead to big problems.
To fix these problems before they occur, you need to understand the different metrics that businesses use to determine business income. Two of these metrics commonly get confused: gross profit and net profit.
Keep reading to learn more about each and discover the differences between gross profit vs. net profit. It could save your startup or small business.
What Is Gross Profit?
Gross profit is the amount of money a company makes after deducting the costs spent on creating and selling its products or services. Gross profit can tell how effectively a business uses labor and supplies to produce goods and provide services.
There are multiple costs that you should consider when looking at your business's financial efficiency, such as:
- Direct labor
- Required materials
- Equipment
- Utilities
- Shipping
- Commissions
On the other hand, gross profit does not consider fixed expenses such as rent, advertising, and insurance. These types of expenses do not directly correlate with creating or delivering your product (COGS or Cost of Goods Sold).
How to Calculate Gross Profit
You will find Gross profit in the upper portion of your income statement beneath revenue and cost of goods sold. To calculate gross profit manually, subtract the cost of goods sold (COGS) from total net sales. Here is the gross profit formula:
Gross Profit = Net Sales - Cost of Goods Sold
Net sales equal total revenue, the cost of sales returns, allowances, and discounts. Keep in mind that revenue is not the same as income.
Do not be fooled by a positive gross profit. Positive gross profit does not mean that your company is profitable.
For example, let's say that your company has a lot of debt leading to high-interest expenses. This drops the gross profit, leading to a negative net profit.
Check out this gross profit calculator to make calculating gross profit easier.
Gross Profit vs Gross Profit Margin
You can calculate your gross profit margin, which looks at the company's efficiency and profitability over time. Here is the formula for gross profit margin:
Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
Multiply the resulting number by 100 to get your gross profit margin ratio.
Your gross profit margin should always remain positive. When your margin is negative, the costs for producing your product are higher than the amount of revenue a product brings in.
What Is Net Profit?
Net profit (also referred to as net income) is the income left over after subtracting all business expenses from the total revenue. Expenses associated with this metric depend on the industry:
- Cost of goods sold
- Administrative expenses
- Income taxes
- Operating expenses
- Loan expenses
- Interest on debt
- Depreciation of fixed assets
Many people refer to net profit as the bottom line because you can find this number at the bottom of an income statement.
Net income portrays a company’s overall financial health and is best when it remains high.
How to Calculate Net Profit
Let’s look at two formulas for net profit.
At it’s the most basic level, you can calculate net profit as:
Net Profit = Total Revenue - Total Expenses
As an example, let’s say that Company A generated $100,000 in revenue in 2021. They had the following expenses:
- Cost of goods sold = $60,000
- Operating expenses = $30,000
- Debt payments = $2,000
- Tax payments = $5,000
- Interest income = $2,000
You would calculate net profit in this example as:
Revenue ($100,000) - Expenses ($99,000) = Net Profit ($1,000)
For a more detailed formula for net profit, use the following:
Net Profit = Gross Profit - Operating Expenses - Other Business Expenses - Taxes - Interest on Debt + Other Income
Net Profit vs Net Profit Margin
Your company's net profit margin shows how much net income or profit a company generates as a percentage of revenue. Here is the formula:
Net Profit Margin = (Net Profit/Revenue) x 100
The net profit margin can tell you whether your business is moving in the right direction. Looking at and analyzing this number can help determine your business' health over time. You should reanalyze this monthly, quarterly, and annual, then compare results to prior periods.
Your business's profit margin will be drastically different from businesses in other industries. To determine how your business stacks up against other companies in your industry, you should look at the average profit margin by industry.
A high-profit margin relative to other companies in your industry tells you that your business operations are efficient and healthy. On the other hand, a low-profit margin relative to other companies in your sector tells you a few things about your business:
- You aren't selling enough
- You have expenses that are too high
- You're pricing products or services incorrectly
- There is a low demand for your products or services
Remember that you're not the only one looking at your net profit margin. Lenders, investors, and other stakeholders may consider your net profit margin to determine business profitability. Net profit margin is also a way for investors to compare two businesses regardless of size because the number is a percentage instead of a dollar amount.
Check out this net profit margin calculator to easily calculate your company's net profit margin.
Gross Profit vs Net Profit
The difference between gross profit and net profit is slim but distinguishable. Both types of profit are essential to understanding your business's financial health.
Gross profit is only part of your company's profitability, while net profit looks at the complete picture. You may think that net profit is more important but gross and net profit measurements are helpful.
The key differences:
- Gross profit shows your operation efficiency based on the money put into products and services.
- Net profit is a direct measure of whether your company is gaining or losing money.
You may have a favorite between gross and net profit, but each can tell you how well your business is running.
What About Operating Profit?
Operating profit often gets confused with gross profit and net profit. But, operating profit looks at a company's profit before removing interest and taxes. Some people may refer to this value as the earnings before interest and taxes (EBIT).
When calculating operating profit, subtract operating expenses from gross profit. Your operating expenses should include any overhead costs like administrative salaries.
Operating profit measures profitability similarly to gross profit. But, net profit looks at all financial components.
Keep Track of Your Profits With Zeni
To keep track of your business's financial health, you need to track various metrics daily, including gross profit and net profit. Getting this real-time financial data is essential when making business decisions and communicating with investors.
Invest in Zen’s AI-powered finance team and intuitive finance dashboard to stay on top of your expenses, profits, revenue, and more. The Zeni dashboard allows business owners to quickly calculate and compare financial metrics like gross vs net profit — no manual work or spreadsheets involved.
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