What is the Difference Between Gross Profit & Net Profit?

Profit is how much money a business makes after its expenditures. We can determine how much profit a business has made by subtracting the expenses incurred by the business and their earnings. Any business person should regularly check their financial statements or income statements to understand their organisational growth. To decide the profit of a business, you should have a thorough knowledge of the difference between gross profit and net profit. Gross profit and net profit are the income that a business earns during different phases of business. Let's learn more about these concepts and their differences. 

What is Gross profit vs Net profit?

 The success of any business is measured by the profit the business makes.  The two important profitability criteria are gross profit and net profit.   

Gross profit: Gross profit is the amount your business makes during a period after subtracting the cost of goods sold. The cost of goods sold includes materials purchases, labour charges incurred, etc. While estimating the total sales, all the sales in an accounting period are considered.  

Net profit:  Net profit is the total amount earned from your business (revenue) after subtracting the cost of goods sold and other operating expenses over a specific period. The expenses include operating expenses, taxes, interest, and expenses incurred during selling. Net profit is also known as the bottom line because it is usually reported at the bottom of the income statement.

Net profit is estimated after deducting all the expenses incurred during that specific period. Below is the list of expenses deducted to arrive at net profit. 

• Operating expenses
• Interest on loan accounts
• Overhead expenses include selling expenses, administrative expenses, and other general expenses.
• Depreciation

 Other income sources such as revenue from investments and the sale of fixed assets are included in net profit.

Did you know?

7.1% of the startups in the world operate in the Fintech industry.

Cost of goods sold

Cost of goods sold refers to the cost incurred in producing finished goods. Cost of goods includes:

• Raw materials
• Wages for labour
• Cost of the equipment required in production 
• Equipment maintenance cost
• Production facilities utility 
• Transportation costs

In the above list, you can note that none of these expenses is fixed. Gross profit depends on variable costs or costs that vary depending on the manufacturing output. Generally, gross profit includes mostly variable costs and not fixed costs. Fixed costs are those, which do not vary whatever the production volume is. The fixed costs include expenses such as rent, salaries, insurance, etc.

However, some businesses divide a part of the fixed cost utilised in manufacturing, and the estimate is based on each unit manufactured. This cost is known as absorbing the cost. For instance, a clothing industry manufactured 10,000 clothes in a quarter, and the company paid Rs 30,000 as building rent, then absorption costing would be estimated at Rs 3 for every unit manufactured.

What is Revenue?

Revenue is the total amount gained after-sales in a particular period. Revenue is also known as net sales because it contains discounts offered, deductions due to returns, or damaged products. For instance, the textile industry usually estimates net sales as revenue, as all the returns and damaged products are deducted from the total revenue. Revenue is also known as the top line as it is always reported at the top of the income statement. 

To determine whether a business is making money or losing money, the understanding of gross profit vs net profit plays a major role. You need to know the accurate value of gross profit and net profit and the difference between gross profit and net profit. The lack of knowledge in knowing the difference may lead to inaccurate financial statements that result in an inaccurate status of your business. So, let us go through the key differences between gross and net profit.

Also Read: Balance Sheet - Definition & Examples (Assets = Liabilities + Equity)

Differences between gross profit and net profit

How to calculate gross profit and net profit?

To calculate gross profit and net profit, we require an income statement. An income statement of a business reveals the cost of goods sold, revenue earned, operating expenses, interest on loans, and taxes. Gross profit is found at the upper side of the income statement. It is just below the total revenue and cost of goods sold. Net income is located at the bottom side of the income statement. It is the result of all the expenses minus revenue.

Gross profit is calculated by deducting the cost of goods sold of a particular business from the net sales. The gross profit formula is:

• Gross profit = Net sales - Cost of goods sold.

Net profit is calculated by deducting all the expenses and costs from the revenue. The income from other sources is also added to revenue before deducting because some businesses have more than one source of income other than the revenue generated from the business. The income sources and costs are reported separately in the income statement. For instance, a business in the service industry will not have manufacturing costs, but all their costs would be operating costs. Similarly, a production-oriented industry would have both the cost of goods sold and operating costs.

The formula for net profit is:

• Net Profit = Total Revenue - Total Expenses

A more elaborate formula to calculate net profit is:

• Net profit = Gross profit - operating expenses - other expenses - taxes - interest on loans - other Income

Example

Let us look at an example to understand better. The below example shows an annual income statement for ABC Technologies for the year 2020. The company has earned a total revenue of Rs. 4,00,000.

Gross Profit = Total revenue- Cost of goods sold

                    = 400000 - 100000

                    = 300000

Any business that is performing well shows a positive gross profit. The money estimated as gross profit is utilised for overhead expenses and income tax. So, for the above example, the gross profit is calculated at Rs. 300000

Similarly, we need to add all the operating expenses, including loan interest and income tax, and subtract it from the gross profit to arrive at net profit. In this particular example, the total expenses are Rs. 220000 (Rs. 140000 + 80000)

Net Profit = Gross profit - expenses.

                 = 300000-220000

                 = 80000

If the net profit is positive, the business owner can pay himself after paying all the expenses.

If the profit is in negative terms, then it is known as a net loss. Net loss usually happens in upcoming and new businesses, and they do not have enough money to pay expenses, taxes, etc. In such a case, the business head should track all his expenses, try to detect areas, and make changes to reduce expenses without affecting the efficiency of the business. A budget should be planned in a strategic manner so that losses in a business can be avoided after-tax deduction. It should include market forecasting and other relevant factors so that business goals and profitability can be achieved.

What do gross profit and net profit tell us?

Gross Profit

• Gross profit measures the efficiency of a business. It estimates how well the business is utilising labour, supplying production, or rendering service to customers. 
• It is one of the important terms when figuring business performance in terms of finance and profit. 
• Gross profit assists in figuring out the expense needed to generate income or revenue.
•  The gross profit decreases in value when the cost of goods sold increases, and so you will end up with less money for your operating expenses.  
• Similarly, the gross profit increases when the value of goods increases, making more money for operating expenses and running the business efficiently. 
• Gross profit is an important factor to determine why a businesses’ profit is increasing or decreasing. This can be determined by looking at the production expenses, labour expenses, and sales.
•  If a business reports an increase in income by increasing production expenses by increasing labour, the gross profit will decrease.  
• Similarly, if a business did not hire labour according to the busy season and had few workers, it would pay more wages for its existing workers. The effect of this is the business would end up with high labour expenses and low gross profit. 

 However, you cannot determine the overall profitability with just gross profit, as all the expenses are not considered. 

Net Profit

• Net profit determines businesses’ health in terms of finance. It reveals whether the business makes more money than what it is spending. 
• Net profit is an important parameter to decide whether or not to expand the business during that particular time and plan to cut out expenses.
• Net income reveals profit from all angles of a business. Accordingly, net income is more comprehensive when compared to gross profit and gives a better understanding of the effectiveness of the business.  
• Change in gross profit has an impact on the net profit. For instance, let’s say a business has reported an increase in gross profit. However, it has borrowed loans for the same, therefore, the additional expense for loan interest will decrease the net income despite increased sales and production.

The drawback of gross profit and net profit

Gross profit and net profit have their drawbacks. The drawback of gross profit is that it is not applied to all industries. For instance, a service-oriented business would not have any production expense or cost of goods sold. Thus, gross profit does not come into the picture. Even though net profit is the complete parameter of a businesses’ profit, it has its drawbacks. Understanding net profit can sometimes be confusing. For instance, if a business sold an asset, the income would increase net profit for that period. There are chances of this profit being misinterpreted as profitability from the business.

Also Read: What is Trial Balance - Meaning, Features and Purpose

Conclusion

Gross profit is the profit in business after deducting the cost of goods sold. It determines the businesses’ ability to make a profit while spending on expenses. Net profit is the profit in business after deducting all expenses from revenue earned. It determines how well the business runs in terms of performance. Gross profit and net profit are equally important, and they reflect business profitability at different phases. Gross profit measures profit by considering only a part of the business income, and net profit measures by including all the sources in the income statement. Understanding the differences between gross profit and net profit will help decide whether a business is making a profit or loss.