When looking at gross profit vs net profit, simply put, gross profit is the amount of money a business makes from products sold after deducting the cost of goods sold.
Net profit is gross profit minus all the operating, tax and interest expenses.
If that went completely over your head, don’t worry! If you’re new to accounting, the jargon can often be confusing and overwhelming.
Gross profit, net profit, operating profit…so many profits
We’re going to break down gross and net profit and explain:
- What gross and net profit are
- What they say about your business
You’ll find these two on the profit & loss report.
Gross profit sits near the top & net profit near the bottom of the report.
What is Gross Profit?
Gross profit is the amount of money a business makes from products sold after deducting the cost of goods sold.
What are the cost of goods sold I hear you ask? These costs, also known as direct costs, are the amount it costs a business to make or purchase a product that they will sell.
If a shoe shop sells 250 pairs of shoes in a month at £50 a pair, then their revenue is £12,500.
It also costs the shoe shop £20 per pair bought as stock. This means that their cost of goods sold is £5000.
This is our equation:
12500 (revenue) – 5000 (costs of goods sold) = 7500
This gives us our gross profit.
The equation to remember is:
What is Net Profit?
Net profit is revenue minus all the operating, tax and interest expenses.
These costs include but are not limited to:
- Business insurance
- Tax deductions
- Any operating costs – including rent, internet, telephone etc.
So, say our shoe shop has operating, tax and interest expenses of £3000 for the month (we’ll cover all these in a future article – so don’t worry about them now!). We would add this and the cost of goods sold together. Then minus that from our revenue.
So this is where we are right now:
12500 (revenue) – 5000 (cost of goods sold) = 7500 (gross profit)
So we now need to minus all our other expenses:
7500 (gross profit) – 3000 (all other expenses) = 4500 (net profit)
This £4500 that our shoe shop is left with is our net profit.
The equation for net profit is:
What does gross profit say about a business?
When looking at the health of a business, gross profit is a better indicator than just looking at revenue for judging the health of your business.
This is because revenue solely indicates the money generated from sales before any expenses are taken off. Just looking at revenue alone is not enough, your revenue might be really high but if your costs of sales are also high this leaves you with very little to cover your operating expenses.
What a healthy gross profit looks like varies from industry to industry. Software as a service (SAAS) businesses tend to have very high gross profit margins. Supplying software through the cloud can be very cheap.
By contrast, selling a physical product tends to yield lower gross profit due to the cost of buying or making each individual unit.
Ultimately, gross profit is a crucial number to keep track of. This figure has to support the rest of your business overheads and financial commitments.
What does net profit say about a business?
Net profit is one of the most important indicators of business health. It shows how much money a business makes after all costs.
Businesses often boast about having a large turnover (revenue) but this means nothing if they aren’t making a profit! It’s great that you can make a large number of sales, but if your costs are equal or higher then it shows your business isn’t in good health.
A high profit and low costs can indicate strong business health. It shows that you’re making enough money to support the business costs and proves your business model works.
However, it is not the complete picture, you can be in profit but still run out of cash! This is why you need to look at the cash flow report too.
Following the example in the image above, the profit and loss report is showing you’ve made 25k. However, the cash flow report is showing it’s not received until next month.
How to improve net profit
So if net profit is so important, how do you improve it?
The main challenge is reducing your overheads and costs of goods sold. This requires looking at your overheads and seeing where you can cut costs.
There are a number of ways you can reduce overheads, here are a few examples:
The best way to ensure your net profit goes up and stays up is to ensure that the cut costs are recurring and not one-off savings.
You also need to make sure that you’re not cutting for the sake of cutting, for example removing a job role might save you a couple of grand a month, but you’ll lose some productivity. In the case of cutting job roles, you should only do so if you’re merging roles or the role truly isn’t needed anymore.
Reducing the costs of goods sold
Reducing your costs of goods sold is another way to increase your net profit.
You can reduce your costs of goods sold in a number of ways:
- Negotiating better prices with suppliers
- Streamlining operations and logistical processes
- Finding alternative, cheaper materials.
You should ensure that any changes you make are not going to affect the quality of your product or service.
If you’re affecting your quality, your sales may go down, undermining the whole point of reducing your costs of goods sold in the first place.
Here’s a quick recap of what we’ve covered regarding gross profit vs net profit:
- Gross profit is the amount of money a business makes from products sold after deducting the cost of goods sold.
- Costs of goods sold are the amount of money it costs a business to make or purchase a product.
- Net profit is gross profit minus the cost of goods sold.
- Net profit is a product of gross profit – net cannot exist without gross.
- Your net profit is on the key indicators of how well the business is performing.
Once you get your head around the jargon of gross profit vs net profit, they become pretty easy to understand and remember.
Last week we discussed the differences between revenue and net profit – check it out here.
For more definitions, explanations & simple guides, check out the rest of our blog.