Gross profit vs. net profit: What’s the difference?
As a small business owner, you should regularly look at your income statements to determine whether your company is doing well. A healthy bottom line is the wish of nearly every business owner, but wishing isn't enough. You need a clear understanding of your profits — or, more specifically, a full understanding of gross profits vs. net profits.
Gross profits and net profits may seem similar at a glance, but the two provide very different information that can be used for a number of things. To help you get the most out of your business (and maybe even attract an investor or two), let's take a look at gross and net profits.
What are gross and net profits?
It's easy to think profits come in one size: the amount of money your business made in a specific amount of time. But this is far from the case. While profits do imply any amount of financial gain, your gross profits and net profits couldn't be more distinct.
Gross profits are the amount your company made over a specific amount of time, minus the cost of goods sold (COGS). The cost of goods sold includes items like raw materials, necessary labor, or even taxes on your building.
Net profits, on the other hand, are your total revenue, minus COGS and all operating expenses — that is, administrative expenses, non-operating expenses like taxes or interest, and any expenses related to selling.
In short, gross profit is your revenue without subtracting your manufacturing or production expenses, while net profit is your gross profit minus the cost of all business operations and non-operations. Your net profit is going to be a much more realistic representation of your company's profits.
But if your net profit provides a more realistic number, you might be wondering why you need to know gross profits at all.
Why do you need to know both gross profit and net profit?
While gross profits precede net profits, the former can be used for more than just calculating the latter. Gross profits provide a view of your company's financial health as it pertains to the cost of goods sold. As a result, gross profit can be especially useful for monitoring how things like your company’s manufacturing and labor costs impact your bottom line before other factors like administrative costs are thrown in.
With your gross profit in hand, you can get an accurate view of your total sales and how they're impacted by the cost of things like raw materials, manual labor, and facility taxes. This can be useful when determining if there are issues impacting your gross margins. Some common concerns include overpaying for raw materials, setting the wrong product price, or even having more workers than you need. Say you realize you're losing most of your gross profit to raw material costs. If so, it might be time to find a new vendor for your materials.
Net profits, on the other hand, can be useful in providing a clearer view of your company's health and potential cash flow. And, unlike your company's gross profit, your company's net profit can be used to attract investors.
When investors are considering which companies to support, they want to know their investment will be a good one. Seeing solid gross profits means nothing if non-operational costs are destroying your bottom line. A positive net profit will send the right signals to investors and increase your chances of attracting one.
How to find gross profit and net profit
Figuring out your gross and net profits is fairly straightforward, especially when you have your books in order. To find both, make sure you have a full rundown of your business expenses, including:
- Invoices for raw materials purchased
- Utility statements
- Depreciation for equipment used in manufacturing
- Packaging costs
- Machinery and tool costs
- Office supply expenses
- Marketing or advertising expenses
- Employee tax and benefit costs
- Employee wages
- Rent or mortgage cost for your space
Both net and gross formulas use the above information, so gather it all ahead of time to make the process as easy as possible.
If you have a recent profit and loss statement, it should contain your cost of goods total. If not, you can determine your cost of goods sold by solving this formula:
"COGS = year's starting inventory + purchases – year's end inventory"
COGS will be used in both gross and net profit formulas, so be sure to keep this number handy once you have it. Use the above formula regularly to keep a finger on your company’s net or gross profits, as COGS will change over time.
Next, it's time to find your gross profit with the gross profit formula:
"Gross profit = sales revenue – COGS"
Now that you've found your gross profit, you can move on to the net profit formula:
"Net profit = gross profit – total expenses"
Again, once you have your net profit, you can give investors a clearer picture of your business. In business, knowledge is power. In this case, net profit gives you the power to make informed decisions when it comes to operational and non-operational expenses, as well as your sales cycle.
Gross profits + net profits = informed decisions
As a small business owner, you likely feel your brain is at capacity when it comes to formulas and financial knowledge. But understanding gross profits and net profits can help you make informed decisions about your business. These decisions can open the door to more opportunities — like attracting investors — and help you take your business to new places.
It will take time, and likely some trial and error, to accurately determine your gross and net profits the first time around. But after doing it a few times, you'll be a seasoned pro and wonder how you ever made decisions without this valuable knowledge.
Better-informed business decisions? You don't need a formula to see the value of that skill.