Profit is the financial gain a business earns. Comparing current profits to previous accounting periods provides insight into the business’s growth. To create accurate financial statements and monitor your business’s financial health, it’s essential to understand two key types of profits: gross profit and net profit.
Gross profit is the income a business retains after deducting the costs associated with manufacturing and selling its products or services. Calculate it by subtracting the cost of goods sold (COGS) from your total sales.
While calculating total sales, include all goods sold over a financial period but exclude sales of fixed assets like buildings or equipment.
What Does Gross Profit Tell You?
Gross profit measures how efficiently a business uses labor and supplies for manufacturing goods or offering services. It is a crucial indicator of profitability and financial performance.
Gross profit reveals the costs required to generate revenue. An increase in the cost of goods sold (COGS) reduces gross profit, leaving less money for operating expenses. Conversely, a decrease in COGS increases profit, providing more funds for business operations.
What is Net Profit?
Net profit is a vital metric indicating your business’s financial health. It shows whether the business earns more than it spends. Net profit can guide decisions on business expansion and expense reduction.
For business owners, it’s important to distinguish between profit and profitability. Profit is an absolute number, equating to revenue minus expenses, while profitability is a relative number (a percentage), representing the ratio of profit to revenue.
Profitability measures efficiency and helps determine business success or failure.
Net profit indicates business profitability. Understanding it offers several benefits:
- Most government and tax forms require you to declare net profit.
- Financial institutions, like banks, use net profit to decide on loan issuance, as net profit is a standard field on business tax forms.
- Lenders and investors examine net profit to assess your ability to repay future debts.
Importance of Knowing the Difference Between Gross Profit and Net Profit
Net profit gives creditors more insight into your business’s health and available cash than gross profit. Investors look at net profit to determine if your business is a worthy investment.
Understanding gross profit trends helps you find ways to reduce the cost of goods sold or increase product prices. If your gross profit is less than your net profit, it indicates a need to cut expenses.
Accurate gross and net profit values are essential for generating an income statement, which reflects your business’s health. Misunderstanding the difference can lead to inaccurate financial documents, presenting an unrealistic picture of your business. Key financial documents guide important business decisions, so accurate profit information is crucial.
How to Calculate Gross and Net Profit?
Use your income statement to calculate both gross and net profit. An income statement shows your company’s total revenue, cost of goods sold, operating expenses, interest, and taxes.
Example: Annual Income Statement for Levo Corp (2018)
- Total Revenue: $200,000
Calculate Gross Profit:
- Formula: Gross profit = Total revenue – Cost of goods sold
- Example: $200,000 – $50,000 = $150,000
Successful businesses show a positive gross profit, which pays for expenses like overhead costs and income tax.
Calculate Net Profit:
- Total Operating Expenses (including taxes and interest): $110,000
- Formula: Net profit = Gross profit – Expenses
- Example: $150,000 – $110,000 = $40,000
A positive net profit means business owners can pay themselves and their partners after covering expenses. A negative net profit, or net loss, typically occurs in new businesses that don’t earn enough to cover overhead costs or income taxes. To avoid net loss after tax payments, track expenses meticulously and develop a budget including potential tax payments. This helps set sales goals that meet financial needs.
Gross Profit vs Net Profit – A Comparison
Gross Profit:
- Measures efficiency in using labor and supplies.
- Calculated as total revenue minus COGS.
Net Profit:
- Indicates overall financial health and profitability.
- Calculated as gross profit minus all operating, interest, and tax expenses.