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How to calculate gross profit

net v gross profit

In business, the terms gross profit margin and net profit margin are often used interchangeably, but shouldn’t be as they both have different uses for business metrics.This guide’s main aim is to assist any individual in understanding the differences between net profits and gross profits. 

Gross profit is the resulting revenue after subtracting the cost of goods sold from the total sales revenue. Gross profit margin is the percentage of the gross profit earned and is equal to the gross profit divided by the total sales revenue, multiplied by 100%. 

Net profit on the other hand is the total revenue left after deducting the total expenses. Net profit margin is the percentage of the net profit earned and is calculated as the net profit divided by the total sales revenue multiplied by 100%. 

Read on to learn about the key differences between gross profit margin and net profit margin, and how each one can be used when assessing a company’s financial health.

 

What is Gross Profit?

Gross profit is the resulting sales revenue obtained after subtracting the cost of goods and services sold (COGS) from the total sales revenue. It’s a metric usually included in the total income statements and it considers all expenses and costs incurred directly while producing and assembling the products. Some of the expenses include raw materials and labour costs.

What is Net Profit?

Net profit is the total revenue a company has left after all expenses have been deducted from the total revenue. This figure provides a clear picture on the revenue left after a company pays off all of its expenses.

Who Needs To Understand Gross & Net Profit?

Any individual or team tasked with handling the financial makeup of a business or company needs to have a reliable understanding of both metrics. These individuals could include CEOs, managers, and business owners, as they are required to have the right insights before making decisions on operations, pricing and investments.

As an individual tasked with making informed decisions relating to the company’s financial progress, having a reliable understanding of both gross and net profit will assist in making informed decisions towards the progress of the company financially. 

These metrics also provide insights on the overall profitability of the business which can help in setting realistic and achievable goals.

 

How To Calculate Each Type Of Profit

Gross Profit Calculation

To calculate gross profit; subtract the cost of goods and services sold from the total sales revenue. It’s a metric usually included in the total income statements and it considers all expenses and costs incurred directly while producing and assembling the products. 

Some of the expenses include raw materials and labour costs. The resulting value, which is the gross profit, is then divided by the total sales revenue and multiplied by 100% to get the gross profit margin.

For instance, if a business generates a total sales revenue equalling £120,000 and the cost of goods sold to generate that revenue is £70,000, the resulting gross profit will be £50,000. The gross profit margin is then generated by dividing the resulting gross profit by the total sales revenue then multiplying by 100%, making the gross profit margin 42% in this instance.

This metric can also be used to value companies among their peers within the same market or industry to understand if they are generating profit and how efficient they are at generating profit. However, gross profit does not account for other expenses made by the company, making it a bit inaccurate for evaluating a company’s profitability.

Net Profit Calculation

Net profit is the total revenue left after deducting the total expenses made, while net profit margin is the percentage of the net profit earned and is calculated by dividing the resulting net profit by the total sales revenue then multiplying by 100%. 

This metric is a very accurate tool for evaluating a business’s profitability and is also used to generate income tax.

For instance, if a business generated a total sales revenue of £150,000 over the year and made a total of £50,000 in expenses in that same year, the net profit generated by the business will equal £100,000, while the net profit margin will equal 67%.

Key Differences Between Gross & Net Profit

Gross profit includes only direct production costs while net profit includes all expenses.

Gross profit only considers the direct costs associated with producing or assembling a good or service. These expenses include things like raw materials, labour and other production costs. While net profit on the other hand includes all expenses and costs. This includes both direct and indirect expenses. Indirect expenses such as marketing, administration and overhead cost.

Gross profit provides a partial picture of profitability while net profit gives a complete picture.

Gross profit is a great and useful indicator for a company’s short-term profitability. This is due to the fact that it only includes direct production expenses. While net profit on the other hand, provides a more diverse indication of profitability, as it includes all expenses, both direct and indirect expenses.

Gross profit margin is typically used to assess short-term profitability while the net profit margin is used to assess long-term profitability.

As stated before, gross profit margin is calculated by calculating gross profit and dividing it by the total revenue, while net profit margin is calculated by dividing the net profit by the total revenue.

Making gross profit a good indicator for efficiency estimates while net profit a good indicator for profitability. Gross profit measures a company’s efficiency in terms of its production costs and total revenue.

Gross profit is more easily manipulated than net profit.

Due to the fact that gross profit only considers direct production costs, it’s typically easy to manipulate. Manipulation of gross profit is easy because there are several ways of cutting direct production 

expenses. For example, a company could make use of lower-quality materials or cut corners on labour. Net profit is more difficult and tricky to manipulate as it includes all expenses and costs. This makes it a more accurate indicator of profitability.

How Is Gross Profit Used In Business?

A high gross profit margin implies that a company or business is efficiently generating profit from its sales. However, a low gross profit margin implies a company is generating low profit from its sales.

  • Banks, investors and analysts make use of gross profit to analyse a company’s financial health and performance to make an effective comparison with other companies within the market.
  • Gross profit is also used to determine a company’s break-even point. Given that the break-even point is the number of units of services that needs to be sold to cover the cost of production.
  • Businesses also use the gross profit to track and evaluate their overall financial profitability and alos identify areas that require improvement and areas to cut costs.  For example, if a company’s gross profit is declining over the years, the company may need to revise its pricing and cost strategy or find other options to reduce its production costs.

By evaluating and analysing gross profit, businesses can make efficient and informed decisions to improve their profitability and cut costs.

 

How Is Net Profit Used In Business?

As indicated above, net profit is the most accurate indicator of a company’s profitability as it accounts all expenses incurred. As such, it provides insights into a company’s financial state and can be used to make informed decisions on how and when to allocate resources as well as make appropriate investment decisions.

  • One of the most common uses of net profit is to determine the return on investment (ROI) of a business. ROI helps investors to assess whether a business is profitable and a good investment choice in the long run. ROI is calculated by dividing the net profit of a business by the total investment made by the business. For example, if a business has a net profit of £1,000,000 and an investment of £10 million, its ROI would be 10%.
  • Net profit can also be used for comparison between business and its competitors in the same market. In general, a higher net profit margin means a business is more cost-effective and profitable than its competitors.
  • Net profit can also be used as an assessment index on the performance of managers and employees.

 

Gross vs Net Profit – Which Is More Important For Your Business?

The answer to this question depends on the business goals and what it aims to calculate. If a business is looking to assess the efficiency of its operations, then gross profit is the better option. However, if the business wants to get the full detail of its profitability, then net profit is the better option.

Both are important metrics when it comes to evaluating a business, but net profit is probably the most important for most businesses. It provides a business with insight on its true profitability and potential, and it’s what most investors and external bodies will evaluate. 

Gross profit is still an important metric, as it can help in evaluating the profitability of products and services offered by a business. Ultimately, the best approach is to keep an eye on both gross and net profit so businesses can get a  complete insight on its financial health and performance and make informed decisions to improve them.

Factors That Can Affect Your Gross & Net Profits

Any business owner or management is aware that profits are essential to business success and growth, so it’s important to have a good grasp and understanding on the factors that can impact it, and how it impacts the amount of profit a business is making.

Factors that impact gross profits:

  • The higher the cost of producing or assembling the goods sold, the lower the gross profit.
  • Volume of sales
  • Costs of raw materials & goods sold
  • Shipping and handling costs
  • Direct labour costs
  • Utilities related to production or assembling such as machine and equipment running costs

 

Factors that impact net profits:

  • Taxes and Legal services.
  • Interest on debt
  • The write-offs for wear and tear on equipment
  • Selling, general, and administrative expenses (SG&A)
  • Overhead costs include rent, building repair & maintenance, insurance, staffing, wages, pension contributions, and marketing. The more overhead a business has, the lower its net profit will be.

 

Other Business Metrics To Track

Other than net and gross profit margin that help in evaluating business performances, there are other key metrics that businesses should take note of and not neglect.

Below is a breakdown of some key business performance tools to take note of in order to understand its overall financial health and performance and where to improve or cut costs

  • Revenue – This is the total amount of money made by a company through sales. Revenue is also used to determine the growth of a business.
  • Cost of goods sold (COGS) – this is the total direct costs incurred during production of the goods or services a company offers.
  • Cash flow – Cash flow is the movement of cash in and out of a business. It’s necessary that the cash flow of a business is calculated or monitored as it tells the business if it has the funds to foot its bills. Cash flow is calculated by taking account of all the money coming in and subtracting all the money going out.
  • Operating expenses (OPEX) – These are the indirect expenses made in respect to running a business. They include things like rent, marketing costs, and staff compensation.
  • EBITDA – EBITDA stands for earnings before interest, tax, depreciation, and amortisation. It is used as an indicator of a business’s overall profitability.
  • Expenses -Tracking expenses will provide the right insights on the cash flow of the business and where to cut costs.
  • Customer acquisition costs – This metric measures the cost incurred to acquire new customers. If customer acquisition costs are too high, profits from the business will be low.
  • Employee turnover – High employee turnover rate can be a sign of bad or below expectation company’s culture or working conditions. As recruitment and training can be expensive, tracking employee turnover will assist in knowing when to make important changes to keep employees happy and loyal, and cut cost in this area
  • Customer retention rate – This metric measures how well a company is at retaining customers. If customer retention rate is low, new and improved strategies should be made to improve it..

Monitoring these key metrics will provide a good overview on a business performance and where to focus to improve the business overall profitability.

Summary

To recap, the main difference between gross and net profit is that gross profit is the total revenue a company has after subtracting direct production cost, while net profit is the total revenue left after subtracting all expenses incurred by the business.

Expenses can include items such as payroll, advertising, and rent. Gross profit is typically used to measure a company’s sales performance, while net profit can be used to determine how efficient a company is at financial profitability.

Ultimately, the best approach is to keep an eye on both gross and net profit so businesses can get a  complete insight on its financial health and performance and make informed decisions to improve them.

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