Gross Profit vs Net Profit: What's the Difference?

In small businesses, the terms “gross profit” and “net profit” are often confused. While they sound similar, they serve different purposes when it comes to understanding the financial health of an entity.

Gross profit does not take into account items such as taxes and one-time charges. On the other hand, net income incorporates these expenses. The latter is a more definitive number that is often used in executive decisions. However, both terms are crucial for a successful operation.

Don't worry if this sounds complex. Affordable small business accounting software can easily automate these calculations. But understanding the fundamentals of these accounting concepts can still be valuable, so let's get into it.

What is gross profit?

Gross profit represents the basic profitability of a company's products or services. It is calculated by subtracting cost of goods sold (COGS) from total revenue. COGS, also known as production costs, includes all the direct costs of creating a product or delivering a service, such as materials and labor. The basic formula looks like this:

Gross Profit = Sales Revenue – Cost of Goods Sold

Let's illustrate an example. Let's say a company sells handmade furniture. To determine the entity's gross profit, add up all revenue from sales to customers. In this case, they sold 10 sofas for $1,000 each, for a total of $10,000.

Next, calculate the cost of materials, such as lumber and nails, and the labor involved in making the product. To make the furniture that was sold, the company spent $3,000 on supplies and $1,000 on payroll, which equals $4,000 combined.

Then, you will subtract the $4,000 in costs from the $10,000 in sales to arrive at $6,000, which is the gross profit.

Gross profit is important because it shows how efficiently a company produces and sells its products. A higher number indicates better efficiency and long-term profitability potential. Conversely, a worse figure suggests there is room to improve operations or increase prices. And a negative number indicates a total loss.

What is net profit?

Net profit, also known as net income, remains after all operating expenses, such as taxes, interest, and other costs, are deducted from a company's gross profit. Simply put, it is what the company makes after paying all costs and overheads.

Net Profit = Sales Revenue – Cost of Goods Sold – Operating Expenses

The term is also known as “bottom line.” If the number is negative, the company lost money.

Here are some examples of expenses that are factored into net profit:

• Rent
• Utilities
• Salaries (other than those included in COGS)
• Marketing expenses
• Losses (theft, fraud, etc.)
• Taxes and other government levies

Crucial executive decisions are often based on net profits. This is because the number is a final, comprehensive measure that quickly conveys the health of a company. After all, no further calculations are necessary for most practical purposes. Compare this fact to gross profit, which is only one part of a larger equation.

Net Profit vs. Gross Profit: Key Differences

Let's recap the main differences between these two essential terms.

Scope of expenses

Gross profit only considers direct costs (COGS), while net profit represents all costs, such as operating expenses, taxes, and interest.

Efficiency indication

Gross profit highlights the efficiency of production and sales, while net profit shows overall profitability, including the effects of overhead, theft, and other operating costs.

Use in business decisions.

Gross profit assists in pricing strategies and controlling production costs, while net profit is crucial for broader financial strategies, investments and understanding the overall financial health of the business.

Examples of gross profits and net income

Now that we've discussed the definitions and basic usage of these terms, let's look at another real-world example.

Gross profit

A bakery sold $20,000 worth of cakes last month. The cost of flour, eggs, sugar, other baking ingredients and direct labor totaled $8,000. The gross profit would be calculated like this:

Gross Profit = Total Revenue – COGS
= $20,000 – $8,000
= $12,000

This $12,000 figure is the gross profit, which indicates the basic profitability of the bake sale.

Net profit

Continuing with the bakery example, let's add other expenses. We'll add rent ($2,000), utilities ($500), marketing ($1,000), and small business loan interest ($500). For the sake of simplicity, we will assume that there are no other expenses related to doing business.

This is what the net profit calculation would look like:

Net profit = Gross profit – Total other expenses
= $12,000 – ($2,000 + $500 + $1,000 + $500)
= $8,000

This amount of $8,000 is the net profit, which reflects the overall financial result after all costs are covered.

Recommended accounting software

Tracking gross and net profits takes time and effort. The most successful companies use accounting software to automate these calculations. Here are two beginner-friendly options to help you get started.

xero

Xero stands out as a solid accounting platform, famous for its easy-to-use interface and comprehensive features. It allows small business owners to easily track their income and expenses, with the added benefit of automatically calculating gross and net profits. Xero offers the advantage of real-time financial tracking, helping to make quick and informed decisions. It also reduces the risk of manual errors by automating routine tasks such as invoicing and bill payment.

Plus, Xero's integration with hundreds of business apps allows for a personalized experience. Your dashboard presents a clear and concise overview of your financial health, making it simpler to understand the profitability of your business.

Patriot Software Accounting

Patriot Software Accounting is particularly known for its affordability and simple approach, making it an ideal choice for small businesses and those new to using accounting software. It makes it easy to track income and expenses, which is crucial for accurately calculating gross and net profits.

Generating financial reports, such as profit and loss statements, is a breeze with Patriot Software. The platform is designed with simplicity in mind, ensuring ease of use without a steep learning curve. This focus on essential features makes Patriot Software a very affordable option for small business owners who need to track their profits seamlessly.

Carry

Gross and net profits are more than just numbers on a financial statement. They are vital indicators of the health and efficiency of your business. These metrics help you make strategic decisions to improve profitability, ensuring the long-term success of your business. Simply put, both gross and net profit go hand in hand.