Woman in green shirt concentrating on laptop

Contents

  1. 1. What is gross profit?
  2. 2. What’s included in gross profit?
  3. 3. What can gross profit tell you about your company’s financial health?
  4. 4. How to calculate gross profit
  5. 5. What is net profit?
  6. 6. What’s included in net profit?
  7. 7. Why net profit matters to your business
  8. 8. How to calculate net profit
  9. 9. Gross profit vs. Net profit: Key differences

Gross Profit vs Net Profit: What’s the difference?

December 19, 2022
Whether you’re a sole trader or running your own small business, understanding the difference between net and gross profit is key.A clear grasp of these two key terms can help give you an overview of the profitability of your business. Without this, you’re at risk of making decisions that could damage your bottom line.If the thought of trying to tell your gross profit from your net profit fills you with confusion, don’t worry. In this post, we’ll explain the key differences between the two terms, how they can be calculated and what each figure means for you as a business owner.

What is gross profit?

Otherwise known as gross income, gross profit is what’s left after all business expenses have been deducted from the total revenue generated.On an individual product, gross profit can be worked out as the selling price of the product minus its production costs. If you’re running a service business, it’s the selling price of your service, minus the costs in providing it.

What’s included in gross profit?

A number of different costs are included within gross profit. These include:
    Delivery charges for shipment to the customerSales commissionsDelivery, or ‘carriage’ as it is known in accounting speakAny changes you may make to the product before sale

What can gross profit tell you about your company’s financial health?

Gross profit can help you understand how profitable your business is and how efficiently it makes use of its labour, supplies and raw materials.To find out exactly how profitable your business is, look to your profit and loss report (otherwise known as your company’s income statement). There, you can compare your profits from previous accounting periods and use this to inform any future business decisions.

How to calculate gross profit

You can work out your gross profit using the gross profit formula:Total Revenue – Cost of Goods Sold (COGS) = Gross ProfitYou can calculate gross profit by deducting the cost of goods sold (COGS for short) from your total sales (otherwise known as your revenue or turnover).To explain this further, here are some examples:
Purchase costSupplier delivery chargeSelling price
Your gross profit is £150 - £100 - £10 = £40You may also hear this referred to as a percentage of sales or gross profit margin. In this example, the gross profit percentage is:£40/£150 x 100 = 27%If your business manufactures products, then calculating the gross profit is a little more complicated.
Raw materialsLabour costSelling price
£25£20£100
Your gross profit is:£100 - £25 - £20 = £55In this example, your gross profit margin is £55/£100 x 100 = 55%

What is net profit?

Net profit is the amount of money your business makes after all expenses relating to business operation costs, interest, depreciation and tax have been deducted over a given period of time.In order to work out your net profit, you must first know what your company’s gross profit is. If the value of net profit is negative, this is considered a net loss.Just like gross profit, net profit is another important way to measure the financial health of your business, as it shows whether your business is making more than it spends.You can also use your net profit figure to help you make strategic decisions about your business, such as when’s the right time to expand or whether you need to reduce your business expenses.

What’s included in net profit?

Like gross profit, net profit includes the following:
    Delivery charges for shipment to the customerSales commissionsDelivery, or ‘carriage’ as it is known in accounting languageAny changes you may make to the product before sale
It also includes overhead costs or fixed costs, including:
    SalariesRentSoftwareBank charges

Does net profit include tax?

In short, no. Net profit is the total amount left over after all expenses, including tax, having been paid.

Why net profit matters to your business

Much like gross profit, net profit is a measure of the profitability of your business. This is the figure used to calculate how much tax is due and will also form the basis of business forecasts.Top tip: If you’re looking to secure investment or apply for credit for your business, net profit is one of the first numbers any bank or investor will ask to see, making it essential that you stay on top of this figure.

How to calculate net profit

Net profit is calculated using the following formula:Total sales – (Cost of Goods Sold + Operating Costs) = Net ProfitThe way to remember this is that net profit is a company’s bottom line. It’s what’s left once all other costs from total sales have been deducted, including all overhead costs, operating expenses, depreciation and tax.To explain this in more detail, take the following scenario:
    Total sales: £50,000Production costs: £10,000Operating expenses: £5000Taxes: £4000
First, you need to calculate your gross profit:£50,000 - £10,000 = £40,000 gross profitNext, work out your operating profit:£40,000 - £5,000 = £35,000You can then use this number to work out your company’s net profit:£35,000 - £4000 = £31,000To work out your net profit margin, simply work out the percentage of sales. If we take the above example into account:31,000/50,000 x 100 = 62%Top tip: You might find net profit sometimes described as net income, so keep in mind that these terms can be used interchangeably. Net income is the bottom-line number on a financial statement.

Gross profit vs. Net profit: Key differences

To recap, gross profit provides a valuable snapshot of how your business is performing and forms the basis of all profit calculations. As it is linked closely to sales, it’s a very good indicator of how profitable a specific product line is. This can be helpful in identifying efficiencies and savings.However, the main limitation of gross profit is that it doesn’t take into account your total expenses, such as tax and salaries, whereas net profit does. You should therefore remember that by focusing solely on your gross profit, you won’t get the full picture of your business’ financial health.As the bottom-line figure, net profit gives a much more accurate reflection of your company’s financial position. With this in mind, you should use this as your starting point for cash flow forecasting and business decision-making.
Caroline Wire
Caroline WireFreelance Copywriter

You might also like

Two people looking at documents on table | How to file a VAT Return

Caroline Wire

·

Startup

How to file a VAT Return: A step-by-step guide

Business woman in white office smiling at pink laptop

Rachel Cameron-Potter

·

Sole Trader

Can a sole trader be VAT registered?

Female business owner on mobile phone

Daniel Hogan

·

Startup

Finding the right VAT Return online software for your business

Don’t take our word for it.

Try Ember for free.

With our super software and talented team of qualified accountants, taking care of your business admin has never been easier. Try us free for 14 days today.

Ember