Profit refers to the revenue you’re left with after deducting the total cost. The main purpose of doing business is to generate profit. Without profit, a business will cease to exist. Keeping a record of your company’s financial state includes calculating profits, which helps you to map out future business decisions. Calculating the profits of your business if important to figure out whether your business plans are working or not. If your revenues don’t exceed your expenses, your business is bound to incur a loss.
We’re going to discuss the two types of profit in business, gross profit, and net profit. You need to have a clear understanding of both to lead your business toward the path of success.
You might want to check What is Gross Income?
Difference Between Gross Profit and Net Profit
To calculate gross profit, one simply needs to subtract the total ‘cost of goods sold’ from the total revenue. What you are left with is the gross profit. Revenue is the total amount of money your company earns in a period, from selling products or providing services.
The cost of goods sold is the total costs that are directly connected with the production. (e.g. raw materials, shipping charges, repairs, direct labor, etc.). Once you deduct the total cost of goods sold from the total money you earned at the same time, you get your gross profit.
One can simply assume that gross profit is the money earned in a specific time (for example- a month) from the total number of transactions or services providing your business conducted. But it’s the money you gain from selling a product, after deducting its production cost. However, a product or service’s journey doesn’t end there. There are other factors to consider after calculating the gross profit, such as- tax, employee’s salary, interest, etc.
Gross profit calculation is an initial stage in figuring out how much your business earned from the entire operation. It doesn’t represent the true profit of a business as the numbers will change after going through the next step of the calculation.
Then again, gross profit does help you in making preliminary decisions as it can point out any weaknesses you might have in your production budget. So you can make adjustments before moving on to the next stage.
Net profit is the stage that comes after gross profit. In this calculation, you need to deduct all the expenses incurred after the production. The lifespan of a product or service is pretty lengthy. After the production, there are still other factors and expenses to consider. Net profit is gross profit minus all expenses.
The costs that arise from the production of a product until the time it reaches the consumer, are total costs or total expenses. These expenses include employee paychecks, rent, utilities, taxes, interests, depreciation, advertisement costs, insurance, etc.
Net profit is the figure representing the real earnings of a business. It is shown at the bottom of the income statement created by the accountant, which is why many refer to net profit as ‘bottom line‘.
The features and formulas of these two calculations have already been mentioned above. You can see that they’re connected but different in their ways. Take a look at their distinct qualities to understand the difference even better:
– The gross profit helps to measure the progress whereas net profit measures the probability
– Gross profit is moved into the profit and loss account, net profit is moved to the capital account
– Gross profit is not dependent on net profit. But net profit is dependent on gross profit as you cannot start your net profit calculation until you’re finished with gross profit
– Gross profit includes income from only the sales or services provided. Net profit includes other income sources as well (operating income, interest income, foreign exchange gain, etc.)
– The intention of figuring out gross profit is to find if any cost-cutting is required in production and net profit helps in evaluating the overall performance of the business
– Gross profit shows a rough profit figure whereas net profit shows the actual profit after the specific accounting period
To calculate gross profit margin, divide the gross profit number by the revenue and show it in percentage. For example, if your company has a revenue of $10,000 and the cost of goods sold is $5,000, then the gross profit would be ($10,000-5,000) = $5,000. So the gross profit margin is ($5,000 ÷ 10,000) x 100 = 50%.
As for the net profit margin, it can be calculated by dividing the net profit with revenue. So, if your company has a net profit of $3,000 with $10,000 revenue, the net profit margin would be ($3,000 ÷ 10,000) x 100 = 30%.
You can use these profit margin formulas to assess the performance of your business and to figure out the current financial status.
To conclude, to get your investors to trust you, you need to give them solid proof of your business’s financial state. With the financial statement, investors can ultimately decide whether you’re eligible for receiving their money or not. To create this statement, you need to have a clear concept about both.
Knowing and understanding the differences will also lead you to take necessary actions depending on the results. If you’re unsatisfied with your gross profit, you know that you need to focus on the cost of production as that’s what affects it.
On the other hand, if your net profit is unsatisfactory, you need to come up with ways to cut expenses. Hopefully, this cleared out any confusion you had about gross profit and net profit and it will help you in your future business expenditures.