As a business owner or manager, understanding the differences between gross profit and net profit is crucial for making sound financial decisions and analyzing your company’s financial health. Though the terms may sound similar, gross profit and net profit refer to distinct measures that serve different purposes.

In this post, we’ll break down what gross profit and net profit are, how to calculate them, and why both metrics matter for your business. Let’s dive in!

What is Gross Profit?

Gross profit is a measure of a company’s revenue after accounting for the costs directly associated with producing its goods or services.

To calculate gross profit:

Gross Profit = Total Revenue – Cost of Goods Sold

Total revenue reflects all the money a company brings in from sales and other income sources. Cost of goods sold (COGS) covers the expenses directly tied to creating products or delivering services. This includes:

• Raw materials
• Labor
• Manufacturing overhead
• Direct labor costs
• Production equipment costs

Gross profit does not account for operating expenses like rent, utilities, marketing, administrative costs, etc. It focuses solely on the income generated from sales after subtracting the costs of production.

For example, if a furniture company sells $100,000 worth of chairs in a month, and it costs them $50,000 to build those chairs, their gross profit is $100,000 (revenue) – $50,000 (COGS) = $50,000.

Gross profit is often expressed as a percentage called gross margin. Here’s the formula:

Gross Margin = Gross Profit / Total Revenue x 100

So if the furniture company above had $100,000 in revenue and $50,000 in gross profit, their gross margin would be 50% ($50,000 / $100,000 x 100).

A higher gross margin percentage is generally better, indicating that a company is efficiently producing its products and services. Low or decreasing gross margins over time could signal problems.

Why Gross Profit Matters

Tracking gross profit is important for several reasons:

• It measures production efficiency and pricing power. Higher gross margins mean a company can produce and sell its offerings for substantially more than cost.
• It helps benchmark similar companies in the same industry. Gross margin percentages tend to follow industry standards. Significant deviations could indicate an issue.
• It highlights production cost issues. For example, if gross profit drops, it may mean production costs are rising. This could require examining supplier contracts, inventory waste, or manufacturing processes to identify where costs are swelling.
• It supports strategic pricing decisions. If gross margins decline, a company may opt to raise prices to stabilize profitability, provided the competitive landscape allows it.
• It impacts valuation. Investors and lenders use gross margin heavily in company valuations, especially for manufacturing firms. Strong gross margins signal efficiency and bottom-line profit potential.

In short, tracking gross profit helps managers understand the profitability of producing and selling their main products and services. It’s a critical money-making activity for any business.

Next, let’s look at another type of profitability metric – net profit.

What is Net Profit?

Net profit, sometimes called net income, refers to a company’s remaining earnings after subtracting all expenses – not just production costs.

Net Profit Formula:

Net Profit = Gross Profit – Operating Expenses

Or for more details:

Net Profit = Total Revenue – COGS – Operating Expenses

Operating expenses include:

• Rent
• Equipment
• Marketing
• Payroll
• Utilities
• Administrative costs
• Sales commissions
• Insurance
• Transportation
• Interest paid on loans

Net profit reflects profitability after all costs of doing business. It measures whether a company’s core operations are profitable. For example, if a software company has $200,000 in revenue, $50,000 in COGS, and $100,000 in operating expenses, their net profit is $200,000 – $50,000 – $100,000 = $50,000.

Net profit margin is another useful ratio, calculated as:

Net Profit Margin = Net Profit / Total Revenue x 100

So if the software company above had $50,000 in net profit on $200,000 in revenue, its net margin is 25% ($50,000 / $200,000 x 100).

Higher net margins mean a company is better at controlling operating costs and wringing profits from total sales. Declining margins could suggest operating expenses are growing faster than revenues.

Why Pay Attention to Net Profit?

Monitoring net profit gives managers crucial insights, like:

• Overall profitability: Net profit illustrates bottom-line profit after expenses. This helps determine if the core business is sustainable.
• Efficiency: Net margin demonstrates how much profit is generated per dollar of sales. Trends here highlight efficiency in managing overhead costs.
• Growth: Increasing net profit over time generally indicates business expansion and compounding returns.
• Valuation: Like gross profit, net profit directly impacts company value. Net profit must be healthy to attract investors and buyers.
• Tax implications: Many small businesses pay taxes based on net profit. Tracking this helps with tax planning and projections.

In summary, net profit is a holistic measure of whether a company’s revenues exceed total costs. It’s a key indicator of fiscal strength.

Now that we’ve defined both gross and net profit, let’s examine the key differences between the two.

Key Differences Between Gross Profit and Net Profit

While gross profit and net profit both measure profitability, they serve distinct purposes for businesses:

Gross Profit	Net Profit
Focuses only on revenue vs. production costs	Accounts for all expenses: COGS + operating costs
Measures efficiency of production and pricing	Measures overall profitability of the business
Helps benchmark manufacturing/product companies	Helps determine the sustainability of the entire business model
Impacts product pricing and inventory decisions	Impacts overall company value and investor perceptions
Formula: Revenue – COGS	Formula: Revenue – COGS – Operating Expenses

Here are some more details on the key differences:

• Expenses considered: Gross profit only deducts COGS related to production. Net profit encompasses all expenses: COGS, salaries, rent, admin costs, etc.
• Use cases: Gross profit helps make product, supply chain, and inventory decisions. Net profit aids high-level strategy and executive decisions about the business as a whole.
• Industry applicability: Gross profit is most relevant for manufacturing and production firms. Net profit applies universally across all companies and sectors.
• Accounting: Gross profit is calculated during the first phase of income statement reporting. Net profit is calculated last after deducting expenses, taxes, interest, and depreciation.
• Malleability: Gross profit can be manipulated by reducing COGS. Net profit reflects the full reality of profitability since all expenses are considered.
• Trends: Gross profit may increase over time as production efficiency rises. But net profit trends ultimately determine the company’s bottom line.

In summary, gross profit is an initial measure of production efficiency. Net profit measures the big-picture profitability of the entire business across all activities.

Gross Profit vs. Net Profit Example

Let’s look at a simple example to illustrate the difference between gross and net profit:

Lucy owns a cupcake shop called Lucy’s Treats. Last month, her revenue from cupcake sales was $15,000. Her cost of goods sold was $5,000, covering ingredients, baking supplies, and kitchen staff wages.

Lucy’s monthly operating expenses consist of:

• Rent: $3,000
• Utilities: $500
• Marketing: $1,000
• Administrative costs: $1,500

Let’s calculate Lucy’s gross profit first:

Revenue: $15,000

COGS: $5,000

Gross Profit = $15,000 – $5,000 = $10,000

So Lucy’s gross profit from cupcake production is $10,000.

Her net profit is:

Gross profit: $10,000

Rent: $3,000

Utilities: $500

Marketing: $1,000

Admin: $1,500

Net Profit = $10,000 – $3,000 – $500 – $1,000 – $1,500 = $4,000

Lucy’s net profit after all operating expenses is $4,000.

This example demonstrates how gross profit only captures production profitability. Net profit encompasses the full, real-world profitability of Lucy’s cupcake shop for the month.

Why do Many Startups have Positive Gross Margins and negative Net Margins?

Here are a few key reasons why most startups tend to have positive gross margins but negative net margins, especially in their early years:

• They focus heavily on building scalable products and acquiring customers, even at the expense of short-term profitability. Their goal is rapid growth and market share rather than immediate profits.
• They reinvest most revenues into expanding capabilities, hiring talent, and accelerating growth. This increases expenses and pushes net margins down.
• They operate at low volumes initially, which makes it hard to cover high fixed costs like rent and salaries. As revenue scales up, those fixed costs get spread across larger sales volumes.
• They offer competitive pricing to attract customers, which keeps revenue high but squeezes profit margins. Over time they can raise prices.
• Developing new products and technologies requires large upfront investments, depressing net margins early on. Profits come later.
• They spend aggressively on marketing and sales to grab market share. Those are big fixed costs before revenues pick up.
• Interest expenses from fundraising and growing working capital need to be added to costs.

So in summary, startups focus first on building the products, team, and customer base. Profitability takes a backseat to growth. But once scale and efficiencies improve, the net margins turn positive.

Strike the Right Balance

Tracking both gross and net profits provides a complete picture of your company’s financial health and performance. But striking the optimal balance between the two is key.

Focusing exclusively on driving gross profit can lead to underinvesting in other parts of the business. At the same time, neglecting gross profit margins can cripple production efficiency.

The goal is to maximize gross profit through efficient production and pricing power, then control operating expenses to deliver strong net profits. This comprehensive approach leads to lasting success.

Related Posts

• 
  Difference between startup capital and working capital
• 
  How to calculate burn rate & cash runway for your startup?
• 
  Key metrics to measure in startup businesses

Key Takeaways

• Gross profit subtracts only COGS from revenue to measure production profitability. Net profit deducts all expenses to assess overall profitability.
• The gross profit helps make pricing, inventory, and manufacturing decisions. Net profit aids high-level strategy and forecasts.
• Gross profit applies mainly to product/manufacturing businesses. Net profit works for all companies.
• Tracking both metrics provides a full view of financial performance. But striking the right balance between gross and net profit focus is crucial.

In today’s competitive landscape, understanding the differences between gross profit and net profit is an essential financial literacy skill for business leaders. Keeping an eye on both can help guide decisions that enable meaningful and sustainable growth.