When securing finance, be it through venture capital or a business loan, it’s essential to get your facts straight when it comes to the figures. Otherwise, you risk delaying the process or even deterring potential investors.
New business owners, or those who outsource their accounting, can sometimes confuse gross profit and net profit. Both are important indicators of business performance and appear on your income statement, but there are critical differences between the two values. As a small business, it’s crucial to understand what each means, as this could affect your pricing strategy, production methods, operating model, and other key decisions.
Fleximize’s financial controller, Elizabeth Page, has outlined her simple explanation of the difference between gross and net profit for business owners and how to report both metrics in your financial statements.
"Gross profit is the money generated by sales after the cost of producing the goods or services has been subtracted. Net profit accounts for these too, but also includes operating costs and other overheads, like payroll, utilities, and rent."
Gross profit is commonly misconstrued as the amount of money brought in by a company for its goods or services. While the reality is slightly more complicated than that, gross profit is still the simplest type of profit for a business to calculate.
How to calculate gross profit
In short, gross profit is the difference in value between the total revenue generated by a product or service and the cost of producing it. The latter is commonly known as 'cost of sales' or 'direct costs' and generally includes expenditures such as raw materials, packaging, and direct labour costs. The formula for gross profit is:
|Gross profit = total sales - cost of goods sold|
Gross profit represents the amount of value gained from the sale of a product or service. However, it doesn’t account for other costs, such as operating expenses (deducted to give operating profit) or other overheads, taxation, interest, and payroll (deducted to give net profit).
Because gross profit doesn’t account for these, it’s important to remember that it doesn’t represent your ‘real’ profit. It’s entirely possible for your gross profit to show a significantly positive figure but for your operating or net profit to be low or even negative. However, this doesn’t mean that the calculation is useless.
What does gross profit show?
Gross profit is useful for working out the value your business generates from its products or services. This can be used to decide if the profit margin for such products or services is acceptable or whether changes are needed, such as cutting production costs or raising prices. This is particularly useful as a first step towards making savings within your business.
It can also suggest if you need to improve your operational efficiency. If your gross profit is satisfactory, but you need to make further savings, you know to look at other areas like your overhead costs. Issues beyond your gross profit margin can be identified using net profit calculations.
Your net profit is essentially your bottom line. It refers to the money that flows into the business from the sale of goods and services minus all running costs.
How to calculate net profit
Net profit is the amount of money a business takes after all costs incurred making that profit have been subtracted. Unlike gross profit, this includes direct operating expenses and other overheads. To work out your gross profit, you need to consider fixed costs like business insurance and rent in addition to outgoings relating to production. The formula to calculate net profit is:
|Net profit = total sales - (cost of goods sold + operating costs + overheads)|
For example, imagine a retail shop selling jewellery bought from a wholesaler. The takings for one year are £200,000. The shop pays £130,000 to the wholesaler, meaning that the gross profit is £70,000. However, the shop costs money to run; there are utilities, wages, rent, business rates, taxes, and insurance. If the total amount of all these things is £40,000, the net profit would be £30,000.
What does net profit show?
Net profit can be a good indicator of your company's financial health and long-term outlook by revealing if it generates more money than it spends. For a lender, stakeholder, or investor, net profit is likely to carry more weight than gross profit when evaluating the viability of a business.
Experiencing a net loss isn't necessarily a sign of trouble, as this can be affected by many different factors, including economic conditions, new legislation, and political shifts. However, if your business struggles to take a net income over several months, you may need to dip into the company's savings. Alternatively, securing a short-term business loan can help your business overcome difficult trading periods.
Many businesses will use profit margin calculations to assess their performance, as well as other key performance indicators (KPI). Thankfully, it's not too difficult to calculate your gross profit margin and net profit margin.
|Gross profit margin|
|Gross profit margin = gross profit ÷ total sales|
|Net profit margin|
|Net profit margin = net profit ÷ total sales|
With a good understanding of gross and net profit, you can assess how your business is performing over time. Tracking your gross profit, for example, will help you to spot any changes in the efficiency of your production lines, issues with product pricing, or weaknesses in management. Additionally, net profit enables you to justify your business model, forecast growth, and instil investors with confidence that your business will be a success.