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Gross Profit vs Net Profit – What’s the Difference?

Man calculating gross profit and net profit for his small business

You often hear the terms ‘gross profit’ and ‘net profit’ in relation to business results. Here we provide a brief explanation of these terms – plus gross profit margin and net profit margin – in relation to small business.

What is gross profit?

Gross profit is sales revenue minus the cost of goods sold. When selling a product or service, the cost of goods sold includes all the costs used to produce that product or service. These costs include direct labour, materials, overhead and other costs that can be directly attributed to the creation and sale of the product or service. You calculate gross profit using the following formula:

Gross Profit = Sales Revenue – Cost of Sales

In effect, gross profit (also called gross margin) includes the variable costs, such as materials and direct labour, that go into producing a product or service. In financial statements, it appears at the top of the income statement, after sales and costs of sales. 

For example:

     Sales: $1,297,128

Cost of sales: $527,723

= Gross profit: $769,405

This figure will vary between industries, so it’s recommended that you only use it to compare between companies in the same industry, offering similar products or services. This is because the cost of sales will vary greatly depending on what is being produced.

What is gross profit margin?

Gross profit margin is based on the same information but shows the results as a ratio, known as the gross profit ratio.  The formula for calculating this figure is:

Gross profit margin = (Sales Revenue – Cost of Good Sold) ÷ Sales Revenue

So using the example above:

($1,297,128 – $527,723) ÷ $1,297,128 =   0.59 or 59%

Although other expenses come into play on the Profit & Loss Statement and determine a company’s success, the higher the percentage the better. A higher number means you have a higher level of profitability based on what has been sold. Again, this figure will vary based on the type of industry. Here’s a list of average margins based on the type of business. While businesses such as legal service providers and healthcare have margin ratios over 90%, car dealers and petrol stations have lower average ratios between 10% and 15%.

What is net profit?

While gross profit shows what you have earned from sales after subtracting the cost of sales. This figure does not account for all the other expenses a company incurs. Many of these are fixed costs that are not affected by the number of products or the amount of services sold. For a manufacturing company, for example, the facility they use to make products will stay the same even if the total number of products increases. The rent or payment for the building will remain the same. If the business grows and needs a larger factory, this will be a new fixed cost, not a variable cost. 

After the gross profit at the top of the profit and loss statement, you have expenses not directly related to producing the product or service. These are known as operating expenses and include items such as payroll, utilities, rent and depreciation. When these expenses are subtracted from gross profit, you get operating profit. 

Finally, after calculating operating profit, you subtract interest and taxes to get net profit, also known as the bottom line.  Once you know what the net profit is, you can calculate the net profit margin. This figure measures what percentage of each dollar the company earns ends up as profit at the end of the year. The formula for calculating net profit margin is: 

Net Profit Margin = Net Profit ÷ Total Revenue

As with the gross profit margin, this number varies greatly between industries. For example, Internet Software and Investments and Asset Management industries have a net profit margin at around 23%, while Retail and Green and Renewable Energy Industries have a net profit margin percentages in the low single digits. 

Gross profit and net profit on the Income Statement (Profit and Loss Statement)

Here’s an example of where these figures sit on a simple income statement. 

INCOME STATEMENT

XYZ Company

Year Ending 30 June 2019

Total Revenue $300,000
Cost of goods sold $50,000
Gross Profit  $250,000
Operating Expenses
Payroll $50,000
Utilities $10,000
Rent $25,000
Depreciation $20,000
Total Operating Expenses $105,000
Earnings Before Interest and Taxes $145,000
Interest $20,000
Taxes  $25,000
Net Profit $100,000

In this example:

  • Gross Profit Margin is ($300,000 – $50,000) ÷ $300,000 = 0.83 or 83%. 
  • Net Profit Margin is $100,000 ÷ $300,000 = 0.33 or 33%.

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