You’ve found our guide understanding net vs. gross profit.
When it comes to running a business, understanding the key difference between gross and net profit is crucial to small business owners. Gross profit and net profit are two key metrics that service as guideposts for you to gauge how healthy your business is.
These principles are also related to understanding cash vs. accrual, how to read your profit and loss, and how to read your balance sheet.
This article covers
- Understanding Gross Profit
- Understanding Net Profit
- What counts as COGS?
- What are good gross and net profit margins?
- What is Operating Profit?
- How to improve Gross and Net Profit
Let’s dive in!
Gross Profit vs. Net Income: An Overview
Gross profit gives you a snapshot of how well your core business activities are performing over a period of time, minus the cost of goods sold. It’s the first indicator on your income statement of whether your product or service is financially viable.
Net income goes a step further by taking into account all your expenses, not just those related to producing your goods or services. This includes operating expenses, taxes, and interest, giving you a clear picture of your business’s bottom line.
How to calculate Gross Profit
Calculating gross profit is essential for businesses, whether they are operating in the Software as a Service (SaaS) industry or dealing with physical goods. Gross profit is the profit made from the core operations of a business before deducting other expenses.
The calculation is simple:
Gross Profit = Net Sales – Cost of Goods Sold (COGS)
Net sales represent the total revenue generated from the sales of goods or services. It can be calculated by subtracting any returns or discounts from the gross sales.
Secondly, calculate the COGS, which refers to the costs directly associated with producing or acquiring the goods being sold.
What counts as COGS?
COGS are also knows as Cost of Sales and include any expenses related to the product or service you sell. The simplest examples of COGS are:
- The wholesale cost of the merchandise in a product businesses
- The cost of producing the work in a service business
For product-based business, COGS means the raw materials used to make your goods, as well as direct labor costs involved in their manufacture. If you buy products for resale, the purchase price of these goods is part of COGS. Additionally, any costs related to getting these products ready for sale, like packaging materials, are included too.
Service-based business owners will include direct costs such as labor (the wages paid to employees directly providing the service) and any materials used in the delivery of your service fall under COGS.
How to calculate gross profit margin
Gross profit margin is the percentage of revenue that remains after deducting the cost of goods sold (COGS).
The formula for gross profit margin is (Revenue – COGS) / Revenue.
For example, if revenue is $100,000 and COGS is $40,000, you have a 60% profit margin
What constitutes a good gross profit margin can vary by industry. For example, industries such as manufacturing and retail tend to have lower gross profit margins due to higher COGS, while service-based industries may have higher margins as they require fewer physical goods.
How to calculate net income
To calculate net income, you need to subtract expenses and costs from gross profit. The formula for net income is:
Net Income = Gross Profit – Expenses
Suppose a company has a gross profit of $100,000. They have total expenses of $65,000.
Net Income = $100,000 – $65,000
Net Income = $35,000
Net Income is typically what your company will pay taxes on, and what’s left over for the business owner or investors after all expenses have been paid.
What is a good net profit margin?
Net profit margin is calculated similarly to gross profit margin.
Net Profit Margin = (Revenue – all expenses) / Revenue
As with gross profit, several factors influence what is considered a good net profit margin. The industry in which a company operates, its size, and its business model can all impact what is considered an acceptable profit margin.
For example, grocery stores typically have a low profit margin, while technology companies can operate with high profit margins. Every sale in a grocery store has direct costs (the cost to the store of the food item), while the direct costs of software sales often go down, as there is not a direct cost tied to every sale.
Operating Profit vs Net Income
But there’s one more factor that differentiates the financial outcomes of your small business: the distinction between Operating Profit and Net Income.
Operating Profit offers a lens into the profitability and operational efficiency of your business, whereas Net Income presents the total financial picture and includes all financial activities. Together, they provide a nuanced view of your business’s financial health, each from its unique vantage point.
What is operating profit?
Operating profit, also known as operating income or operating earnings, tells you how profitable you are, but factoring in your operating costs only.
Operating costs are exactly what they sound like: the costs associated with your business operations.
- Rent and utilities
- Payroll
- Marketing and advertising
- Insurance
- Office supplies and software
- Administrative costs
Subtract all operating costs from gross profit to arrive at operating profit. Now you know how much profit is left over after all your regular costs.
Net Income
Now, to arrive at total net income, we have to subtract or add all non-operating expenses and other revenue sources. These include:
- Tax payments
- Interest
- Depreciation & amortization
- Exchange rate gain or loss
- Gain or loss on asset sales
- Grant income
- Tax rebate income
- Interest or dividend income
These costs and revenues are not part of your operations but they are a part of your entire business expenses.
Operating profit is related to EBITDA, which stands for Earnings Before Interest, Tax, Depreciation & Amortization. Investors, lenders, and other stakeholders look at EBITDA when evaluating financial statements to understand how much it takes to operate your business, before the non-operating expenses and income are factored in.
How to improve Gross and Net Profit
Most small business are trying to increase their overall profitability. The first step is looking at ways to improve gross profit, then operating profit, and finally, net income.
Improving Gross Profit
Improving your business’s Gross Profit involves strategies to either increase sales revenue, decrease the cost of goods sold (COGS), or both. Here are some actionable steps small business owners can take.
For product businesses you can:
- Increase Product Prices: If your market research supports it, raising prices can boost your gross profit margin. However, this needs to be done carefully to avoid losing customers to competitors.
- Reduce Direct Costs: Negotiate with suppliers for better prices or look for alternative suppliers who can offer lower rates without compromising quality. Buying in bulk often secures discounts.
- Enhance Product Mix: Focus on selling higher-margin products or services. Analyze your product line to identify and promote the most profitable items, possibly reducing focus on lower-margin ones.
- Increase Operational Efficiency: Streamlining production processes or investing in technology can reduce labor costs and waste, thus decreasing COGS.
- Quality Control: Implementing or enhancing quality control measures can reduce returns and warranty claims, directly improving your gross profit.
For service businesses you can
- Optimize Service Pricing: Regularly review and adjust your service pricing based on market demand, perceived value, and competitor pricing. Implementing tiered pricing models for different levels of service can attract a wider range of clients.
- Reduce Service Delivery Costs: Identify the most cost-effective methods for delivering your services. This could involve streamlining processes, automating certain tasks, or renegotiating terms with suppliers and subcontractors.
- Improve Employee Productivity: Training and technology investments can make your team more efficient, allowing you to serve more clients or complete projects faster without sacrificing quality. Consider incentive programs to motivate staff to work more efficiently.
- Expand Service Offerings: By broadening your service portfolio to include high-margin offerings, you can increase overall profitability. Analyze customer needs and market trends to identify new services that align with your business’s strengths.
- Focus on Niche Markets: Specializing in specific niches can allow you to charge premium prices due to specialized expertise and reduced competition. Identify niche markets where you can offer unique value.
Improving Operating Profit
Reducing costs and streamlining operations is the next step to improve Operating Profit. Some targeted strategies include:
- Streamline Operations: Review your operational processes for inefficiencies or redundancies. Reduce waste, improve productivity, and lower costs associated with delivering your products or services.
- Lower Overhead Costs: Examine fixed overhead costs such as rent, utilities, and administrative expenses to identify potential savings. This could include relocating to a less expensive location, doing remote working, reducing utility usage, or transitioning to more cost-effective software solutions.
- Optimize Staffing: Ensure that staffing levels are aligned with your company needs. Consider cross-training employees to handle multiple roles efficiently or using part-time or freelance workers during peak periods instead of hiring additional full-time staff.
- Invest in Technology: While initially costly, investing in technology can significantly reduce long-term operating costs. Automation tools, for example, can streamline administrative tasks, improve inventory management, and enhance customer service efficiency.
- Outsource Non-Core Activities: Evaluate the cost-benefits of outsourcing functions that are not central to your business operations, such as IT support, payroll processing, or cleaning services. Outsourcing can convert fixed costs into variable costs and free up resources for core business activities.
Implementing these cost-focused strategies requires a careful examination of your company’s operations and a willingness to make tough business decisions that can lead to long-term financial health and improved Operating Profit.
Improving Net Income
These strategies involve managing and reducing expenses not directly tied to your core business operations, as well as identifying new sources of income. Here’s how:
- Reduce Interest Expenses: If your business carries debt, look for opportunities to refinance high-interest loans at lower rates. Consolidating multiple debts into a single loan can also reduce total interest payments and monthly outflows.
- Minimize Tax Liability: Work with a tax professional to ensure you’re taking advantage of all applicable tax deductions and credits. Effective tax planning might include strategic investments, tax-deferred savings plans, or making charitable donations that can also benefit your business’s public image.
- Leverage Financial Products: Financial products like cash-back credit cards or merchant services that offer rewards can provide additional income or savings. Ensure these products align with your business operations and spending patterns to maximize benefits.
Conclusion
We’ve taken a deep dive into the financial side of your business, getting a handle on the primary difference between the money you make just from what you’re selling (gross profit) and what your company actually gets to keep after all is said and done (net income). It’s like looking under the hood of your car; you see what’s powering your business and what’s dragging it down.
For those selling products, we talked about smart moves like tweaking your prices, getting a better deal on your materials, and selling more of the stuff that gives you the best bang for your buck.
If you’re in the service game, it’s about getting your prices right, cutting down the costs to deliver your services, and maybe adding a few more offerings that don’t cost you much but add a lot of value for your customers.
Then, we hit the operation side of things. Cutting the fat—spending less on the day-to-day stuff, from supplies to the space you’re renting, and even getting a little tech-savvy to make things run smoother.
And finally, boosting that bottom line, your net income. Here’s where you get a bit crafty, looking into things like not paying more interest than you need to, keeping the tax man at bay by smartly managing your money.
By now, you’ve got a toolkit to not just make your business run but to make it sprint. Here’s to making your business not just survive but thrive.
Next, check out our articles on bookkeeping basics, bookkeeping vs accounting, and how to read your profit and loss.
FAQ: Gross vs. Net Profit
Here's some answers to commonly asked questions about gross vs. net profit
What's the Difference Between Gross Profit and Net Profit?
Gross profit is the amount your business makes after subtracting the costs directly linked to making and selling your products or services (COGS). It’s like your business’s raw earning power before any other expenses are taken into account.
Net profit, on the other hand, is what remains after all your business expenses—not just COGS but rent, utilities, salaries, and taxes—are deducted from your total revenue. It’s the true bottom line, showing what your business actually keeps as earnings.
Gross profit gives you a snapshot of production efficiency, while net profit reveals overall financial health and profitability.
What's the Difference Between Operating Profit and Net Income?
Operating Profit is what your business earns from its core activities, minus the day-to-day expenses needed to keep the doors open. This includes costs like wages, materials, and overheads related to producing and selling your product or service. It doesn’t account for taxes, interest payments, or any income and expenses not directly tied to the core business operations. Think of operating profit as a measure of your company’s operational efficiency—how well it generates profit from its primary business activities.
Net Income, on the other hand, is the grand total of what your business makes after everything is accounted for. This means it includes not just the operating costs but also subtracts taxes, interest payments on debt, and includes one-off items like sale of an asset or earnings from investments. Net income gives you the bottom line: the actual profit that’s left over and can be distributed to shareholders or reinvested back into the company.
How Can I Improve My Gross and Net Profit Margins?
Improving your gross profit margin involves either increasing sales revenue without proportionately increasing COGS or reducing the costs of goods sold directly. Strategies include optimizing pricing, improving product mix, and negotiating better terms with suppliers.
To enhance your net profit margin, focus on reducing both direct and indirect expenses. This can involve cutting operational costs, minimizing non-essential spending, and implementing efficient processes.
Additionally, exploring new markets or revenue streams can boost overall profitability. Regularly reviewing financial reports and adjusting strategies as needed are crucial steps in maintaining healthy profit margins.
