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Gross profit is your profit after subtracting the cost of goods sold. Net profit includes all income and expenses. Keep reading to learn more.
You may have heard that profit margin is high on the list of essential business metrics to track. But did you know that there are actually two types of profit margin?
After reading this article, the next time someone will ask, “What’s the benefit?” your answer should be “Gross or net?”
What is Gross Margin?
Gross profit, also known as gross profit margin, is a company’s profit after subtracting the cost of goods sold (COGS).
Gross Profit = Net Sales – Cost of Goods Sold
Net sales refer to the money, cash, or credit your business earns from the sale of its products, less any returns, rebates, and allowances. For manufacturing companies, the cost of goods sold consists of three parts: direct labor, direct materials, and manufacturing overhead. Cost of goods sold for commodity businesses includes only the cost of acquiring goods for resale.
Businesses use gross profit to gauge how much of their revenue is spent creating or buying inventory. The multi-step income statement, which your accounting software can prepare for you, lists the gross profit.
The multi-step income statement lists the gross profit. Image source: author
Be sure not to confuse gross sales with net sales. The $250,000 figure in the income statement above is gross sales, which includes sales returns, rebates and allowances. Net sales, sometimes referred to as net income, reflect your company’s turnover more accurately than the gross amount.
You can also express gross margin as a percentage or gross profit margin ratio.
Gross profit margin ratio = [(Net Sales – Cost of Goods Sold) ÷ Net Sales] x100
How to Calculate Gross Profit
Use the gross margin formula, net sales minus cost of goods sold, to calculate gross margin.
Let’s say a company’s net sales totaled $100,000 last year. If the COGS is $30,000, the gross profit is $70,000.
The gross margin rate is 70% ([($100,000 – $30,000) ÷ $100,000] x100).
Now consider another company with net sales of $150,000 and a COGS of $85,000, resulting in a gross profit of $65,000 ($150,000 net sales – $85,000 COGS).
Gross profit can better indicate the success of the business than net sales. While the first company had lower net sales, it made a higher gross profit than the second company. Without knowing the other expenses of the companies, it seems that the first is doing better.
What is net profit?
Net profit, also known as net income, is the amount of money a business earns after taking into account all expenses. This is the bottom line on the income statement.
Net Profit = Total Income – Expenses
The net profit formula takes into account all the income and expenses that a business incurs. Companies do not include the distribution of cash dividends in this calculation.
Creditors and investors look at your net profit, also known as net profit margin, to find out if your whole business is profitable. If you have a net profit, your income is greater than your expenses. When expenses exceed income, you have a net loss.
You can also express net profit as a percentage, called the net profit margin ratio:
Net profit margin ratio = [(Total Revenue – Expenses) ÷ Total Revenue] x100
How to Calculate Net Profit
You calculate net profit by subtracting all expenses from total income. The net profit calculation includes non-operating income and expenses such as interest and taxes.
Net profit is different from operating profit, which does not include interest and income tax expense.
Consider the following income statement.
Net profit is presented as the bottom line of the income statement. Image source: author
All business expenses are taken into account in the calculation of net profit:
- Cost of Goods Sold: Direct material, direct labor and manufacturing costs associated with creating and distributing your products.
- Operating Expenses: Expenses related to the management of your main business activities.
- Non-operating expenses: Expenses incurred outside of your main business activities, including interest.
- The income tax charge: I’m sure you already know this one.
Gross Profit vs Net Profit: What’s the Difference?
Although both are used to assess the profitability of a business, gross profit and net profit differ depending on the types of income and expenses accounted for in each formula.
Gross Profit = Net Sales – Cost of Goods Sold
The gross margin calculation focuses only on income and expenses that you can directly relate to your products. Since interest income, machinery sales, and most operating expenses are not directly related to your products, they are excluded from the gross margin calculation.
Net Profit = Total Income – Expenses
Net profit includes all income and expenses incurred by your business. Unlike gross profit, which only considers product costs, the net profit calculation includes both product and period costs.
Let’s take a look at some of the general ledger of Gotta Lick It Up, a local ice cream shop.
|
Account |
Amount Balance |
|---|---|
|
Turnover |
$200,000 |
|
Cost of Goods Sold |
$30,000 |
|
Payroll expense |
$50,000 |
|
Charge of social charges |
$5,000 |
|
Equipment maintenance |
$15,000 |
|
rent expense |
$30,000 |
|
income tax expense |
$15,000 |
To calculate gross margin, subtract sales revenue from cost of goods sold. Gotta Lick It Up’s gross profit is $170,000 ($200,000 revenue – $30,000 COGS).
Net profit, which includes all expenses, totals $55,000 ($200,000 – $30,000 – $50,000 – $50,000 – $5,000 – $15,000 – $30,000 – $15,000).
When should you use gross profit instead of net profit?
Whether you use gross profit or net profit to communicate the financial health of your business depends on the question.
The next time someone asks you if your business is profitable, you should answer with the net profit or net loss of your business. Profitability usually refers to the health of your entire business, not just the revenue you earn from your products.
A question about the profitability of your products concerns your gross margin. Investors often ask for your gross profit to understand if you have priced your product correctly.
When I say “benefit”, you mean…
“Gross or net? »
Both gross profit and net profit provide valuable information about the health of your small business. Use these numbers to articulate the profitability of your business.
