Gross Profit vs Net Profit: Definition, Differences, Formula & Examples

Accounting
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Fincent Team

Your profits tell you how well your business is doing. It shows you your business' financial health at any given point in time, so you can make decisions about how to improve or sustain it. You can even compare the profits for different periods to check whether your business is improving or not.

So, is gross profit more important, or net profit? What should you concentrate on?

Let's find out.

Gross Profit vs. Net Profit

The reason you are in business is to make a profit. When your revenues exceed your expenses, you make a profit, and when your expenses exceed your revenues, you make a loss. So, your goal should always be to keep your expenses to the minimum without affecting the quality of your product or service.

As a business owner, you get what is left after paying taxes on your profits. Your profits also tell you how well you are doing compared to the competition. You can then either take out this profit or invest it in your business for its growth.

Calculation of Gross Profit

Certain costs are directly associated with production. This is defined as the cost of goods sold (COGS) and includes the cost of raw materials and labor that go into creating a product. When you deduct the cost of goods sold and goods returned by customers from your gross revenues, you get the gross profit.

To ensure that you can focus on your business' growth, Fincent saves you time and money by providing affordable bookkeeping services. An example will clarify the concept of gross profit.

Gross Profit = Revenue - Cost of Goods Sold - Returns From Customers

Let's take the example of a man named David Lee. His graphic design company made $350,000 in revenues for 2020. The COGS was $115,000, and customers returned goods worth $5,000.

Apart from labor and raw material costs, there are several other overheads required to run a company. These are administrative and selling expenses and taxes, after which you get the bottom line or net profit. Let us find out what net profit is and how it is calculated.

Calculation of Net Profit

Net profit is what is due to you as a business owner. All other expenses that are not directly related to production are deducted from the gross profit to arrive at the net profit. These are general, administrative, and selling overheads that are required to run a business.

The expenses for calculating net profit include interest, depreciation of equipment, administrative staff salaries, and income tax. Some of these expenses have to be paid even if there is no production. Interest on a bank loan, for example, has to be paid every month as EMI whether or not you're making a profit.

Gross Profit - General, administrative, and selling expenses = Net Profit

Let's go back to David Lee's example. The general, administrative, selling expenses are $45,000, and interest expenses are $5000.

Gross Profit and Net Profit on the Financial Statements

You can find the gross profit and the net profit on your income statement. The income statement includes the expenditure you incur and the revenues earned for a particular period. At the end of the period, you deduct all the expenses from the revenues to calculate whether you have made a profit or loss.

The gross profit appears near the top of the income statement. The reason for this is you need to first calculate the cost of producing the goods or the cost of goods sold. The lower the cost of goods sold, the higher the efficiency of your labor, and the higher your gross profit.

The net profit appears at the bottom of the income statement after all expenses have been deducted. The difference between gross revenue and net revenue is that while the latter is calculated using direct production costs, net revenues are calculated after accounting for indirect costs as well. Net revenues are what a business owner is entitled to.

The administrative expenses don't add to the gross revenues of a company but are important nonetheless. For example, you need an efficient sales and marketing team to sell your products. Advertising costs are essential for creating brand awareness, and your HR department is required to hire the right resources.

Let us check out the income statement of David Lee's graphic design company to get a better idea.

David Lee Designs
Income Statement
For the Year Ended March 21, 2020

Gross Profit vs. Net Profit: Why it Matters

Calculating gross profit or net profit involves a lot of calculations and time, so why do you need these figures?

As a business owner, the more productive your workforce is, the more profits you make. Higher efficiency means producing the same quantity with lesser raw materials or a higher quantity with the same raw materials. If you automate some of your processes, you could bring down your COGS.

If you can lower your cost of goods sold without compromising quality, you have a higher gross profit. If you find that your gross profit is high and you are still making a low net profit, you need to check your indirect expenses.

If your gross profits don't go up despite higher efficiency, you need to increase your prices. Adding new products would be another option for improving gross profits. You could explore new markets to market your product at higher margins.

One reason for a higher cost of production could be poorly maintained equipment. You need to focus on things like preventive or predictive maintenance to ensure your equipment performs at an optimal level. With fewer breakdowns, your machines will perform better, and your productivity increases.

Indirect expenses are important for the success of your business, but they could hurt your net profits. If advertising costs have gone up without an increase in sales, you need to find out why. It could be because the agency you've partnered with isn't the right fit. If this is the case, you'll need to make a change.

If the economic situation is bad, then you might want to assess the rent on your current premises. If your rental contract has an exit clause, you can look for other premises in the neighborhood at a lower cost. When you save on rent, your net profit goes up.

Another possibility is that your current loan could be charging a higher interest rate, despite a drop in current interest rates. You should ideally talk to your banker to shift to a loan with lower interest rates in such a situation. By doing this, your administrative expenses will go down, and net profits will increase.

You also need to keep an eye on your sales team to track their performance. Underperformers could be trained or laid off. You could also automate parts of your sales process to lower costs and indirect expenses.

In Conclusion

By controlling your direct and indirect costs, you can improve both your gross and net profits. This article has outlined several reasons why both these figures are important to your business, along with highlighting their differences.

If you find managing your books particularly tedious, especially when you'd rather be focusing on scaling your business, consider partnering with Fincent's expert bookkeeping services.

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