You’ve probably heard of, or use the terms, “gross” profit and “net” profit in the course of business, but the actual definition can sometimes be confusing or unclear.
In this post we will explain:
- The difference between gross and net profit
- When to use them
- Why they are important
You can read the previous posts in our Financing Basics series below:
The difference between gross & net profit
When reading a company’s income statement, two of the most important line items are gross profit and net profit. Although they sound similar, they have fundamental differences and provide different information to the reader.
Before we jump into the differences, they do have one fundamental similarity. They both follow the same formula:
Profit = Revenue – Expenses
The difference between gross profit and net profit is which expenses are included in the equation.
Gross Profit = Revenue – Cost of Goods Sold Expenses (COGS)
Net Profit = Revenue – All Expenses
Net Profit = Gross Profit – Operating Expenses
COGS are the expenses directly associated with creating the products you sell such as manufacturing and materials. A good way to remember which expenses are included in COGS is to ask yourself: If I didn’t pay this expense would I be able to acquire inventory? If the answer is no, then it is included in COGS.
Operating expenses are the costs associated with selling the items and running the business such as advertising costs, interest payments on outstanding loans or payroll.
When to use gross & net profit
Gross and net profit are most commonly seen in a company’s income statement. In its most basic form, an income statement tells the reader how profitable a company was over a specified time period (usually a quarter or a year).
When reading an income statement, you always begin with the revenue, and the further down you go the more expenses get subtracted until you end up with the net profit.
Figure 1. An income statement showing how revenue, gross profit and net profit interact.
Why net and gross profit are important
Simply put, these terms tell you where to spend your time and money.
With the end goal of most businesses being to increase net profit, you can look through the income statement to see what can be adjusted to make this increase in net profit a reality:
1) increasing revenue
2) reducing COGS (therefore increasing gross profit)
3) reducing operating expenses (therefore increasing net profit)
You can look at how your gross and net profit compare as a % of revenue vs companies in similar industries (public companies release their financial statements quarterly. You can find them on the SEC website here). Once you have an idea of which areas are weaker, you can start going through each line item to find specific costs to reduce.
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