Gross profit and net profit are two important profitability metrics. Both these terms offer valuable insights into a company’s financial performance history.
Let us discuss what are these terms and the key differences between them.
What is Gross Profit?
Gross profit is the amount of profit a business makes after deducting the costs to produce goods from sales revenue.
It is the most basic and primary form of profitability measure. It is commonly used to measure the production efficiency of a business.
Gross profit can be calculated by using two inputs: revenue and cost of goods sold. However, businesses must evaluate the results critically when planning for operational efficiency.
Revenue
This is the starting point for calculating gross profit. It is the sales through products/services of a business.
The total revenue of the business is the direct result of selling products. It does not include investment or financing income (interest).
Evaluating the revenue figures and comparing them against profitability metrics can help understand a business pricing strategy. Businesses can then adjust prices and manage revenue accordingly.
COGS
The cost of goods sold (COGS) is the direct cost of producing products or services. These costs include raw material, direct labor, and other direct input costs.
The COGS figure also reveals the operational efficiency of a business. It shows how well a business is utilizing the available resources.
Businesses can evaluate the supplies and raw material prices, compare suppliers, and plan accordingly for output levels.
Deducting the COGS from the total revenue figures gives us gross profit. The business will then refine and deduct other expenses to arrive at the net profit.
Gross Profit Margin
Gross profit margin is a percentage term to describe the gross profit of a business. It translates the absolute dollar value into a percentage term.
Gross profit margin is a useful tool to analyze and compare the performance of a business in terms of revenue generated. It can be used for internal and external benchmarking as well.
How to Calculate Gross Profit?
Gross profit can be calculated easily by deducting the cost of goods sold from the total revenue figure.
The formula to calculate the gross profit is:
Gross Profit = Revenue – Cost of Goods Sold
Similarly, the gross profit margin can be calculated using the formula:
Gross Profit Margin = [(Revenue – Cost of Goods Sold) / Revenue] × 100
It can be calculated in a few simple steps.
STEP 01:
Calculate the total earnings of a business. This figure includes revenue generated from direct sales of products and services.
Any refunds or returns should be adjusted to reflect the true value of sales in a given accounting period. It is simply calculated by multiplying the unit price by the number of units sold in the given period.
It includes both cash and credit sales.
STEP 02:
The second step is to calculate the cost of goods sold. These are direct and indirect costs incurred to produce products/goods to be sold.
These costs include material, labor, machinery, and rentals that are directly linked with the production process.
Note: Overheads and admin costs are excluded from the COGS calculations.
STEP 03:
Then, you can calculate the gross profit figure by deducting the COGS from the total revenue figure.
In percentage terms, you can easily convert it into the gross profit margin.
Importance of Gross Profit
Gross profit is one of the several profitability measures. In most analyses, it provides a starting point to analyze the operational efficiency of a business.
Analyzing both components of gross profit and comparing them with historic trends provide useful information. Businesses can then decide between adjusting prices, production volume, and input metrics.
Gross profit can also be optimized by increasing sales and marketing efforts. However, analyzing the causes of fluctuation or underperformance can reveal the reasons behind it.
When converted into the gross profit margin, it can be used for benchmarking analysis. Businesses can compare trends with historic results and against industry standards.
What is Net Profit?
Net profit is a profitability measure that refers to the net income of a business after paying all types of expenses. In other words, it is total revenue minus total expenses.
Net profit or net income is considered the bottom line of any business. It includes all types of revenues including direct sales, investment income, interest earnings, and any other comprehensive income.
Net income can be described in different ways. It can also refer to profit after taxes and adjusted for other income.
Net profit can then be used to calculate different other profitability measures such as EBITDA and EBIT as well.
A business can use different types of revenue and expense sources. Generally, the revenue and expense categories to arrive at the net profit figure include the following:
- Total revenue
- COGS
- Operating expenses
- Overhead expenses
- Interest costs
- Taxes
- Depreciation or amortization
Net Profit Margin
Net profit margin converts the absolute value of net income into a percentage figure. It can be compared with the gross profit margin.
It gives another useful analysis tool for profitability analysis for benchmarking and efficiency analysis.
How to Calculate Net Profit?
The formula to calculate net profit can be written in a few different ways.
Net Profit = Total Revenue – Total Expenses
Or
Net Profit = Gross Profit – Operating Expenses – Other Expenses – Interest – Tax costs + Other Income
Similarly, we can convert it into the net profit margin.
Net Profit Margin = [(Total Revenue – Total Expenses/Total Revenue)] × 100
Or simply,
Net Profit Margin = Net Profit/Total Revenue × 100
Let us elaborate on the calculation steps in detail.
STEP 01:
Determine the total revenue for the given accounting period. It is simply determined by multiplying the unit price by the number of units sold.
It should include cash and credit sales.
STEP 02:
The next step is to calculate the cost of goods sold. These are the direct and indirect production costs for selling products/services.
STEP 03:
The third step is to calculate the operating expenses of a business. These costs include administration and selling costs, marketing, and advertising costs.
In this step, you can also calculate non-cash adjustments like depreciation and amortization.
STEP 04:
In this step, you can calculate the finance costs of a business. These are interest payments on all types of loans.
You can also calculate the tax liabilities for the given accounting period in this step.
STEP 05:
Finally, you can use the formula given above to calculate the net profit for a given accounting period when all the input metrics are ready.
Importance of Net Profit
Net profit is called the bottom line of a business and for good reasons.
It is the profit left after paying all expenses and what is left for the shareholders of the company. In that sense, the accumulated net profit (retained earnings) of a business is the net worth of a business.
Net profit also helps a business in analyzing how good it is in converting its sales into net profit. Gross profit is a basic profitability term that excludes several types of expenses.
It means even if a company generates more revenue, it does not necessarily mean it would translate into higher net income.
Therefore, analyzing net income provides useful insights into a company’s total profitability. It also reveals how well a company is utilizing its resources both in terms of financials and operations.
Gross Profit Vs Net Profit – Key Differences
Let us now summarize the key differences between these profitability measures.
| Metric | Gross Profit | Net Profit |
| Definition | A profitability term is a total revenue minus the cost of goods sold. | A profitability term is a total revenue minus total expenses. |
| Formula | Gross profit = Revenue – COGS | Net Profit = Revenue – Total Expenses |
| Uses | – Profitability and efficiency analysis – Product pricing and production level analysis – Analysis of supplier relations and raw material prices – Operational efficiency – Analysis of direct and indirect production costs | – Profitability and efficiency analysis – Direct and indirect costs of production – Operating expenses, financing costs, and taxes – Non-cash expenses – Other income and other costs |
| Advantages | – A simple profitability measure – Easier to calculate and understand – Can be converted into a percentage term – Used by managers, shareholders, and lenders – Shows how well a business manages direct costs, production, and sales | – Shows the bottom line of a business – Provides a comprehensive overview of a business – Includes all types of expenses – Includes depreciation as well – Establishes a relationship between sales, operating costs, financial costs, and net income. |
| Disadvantages | – Does not account for all expenses – A static figure does not reveal much – Has to be converted into a percentage or trend for better analysis – Can be misleading at times if considered as a standalone parameter | – It is dependent on revenue like gross profit – Requires a percentage term or trend analysis – Should not be used as a standalone profitability measure – Can be manipulated with non-cash and accounting adjustments |
