I. Introduction
Gross profit and net profit are two important financial metrics for any company. They measure its profitability for investors or potential creditors. However, these two financial metrics are inherently different. As an investor, you need both of them to analyze a company’s credibility before investing in its stocks.
Today, in this blog, we will discuss the difference between the gross profit and net profit of a company, along with their definition, calculation methods, uses, examples, benefits, limitations, and more. We will also highlight key methods or strategies to enhance the gross profit and net profit of a business to increase overall profitability and attract more investors to the business. So, let’s dive in and learn about gross and net profit in detail.
II. What is gross profit?
Gross profit usually refers to the remaining profit or income once the production cost is subtracted from the revenue of the company.
A. Definition and formula
By this definition, the gross profit of a company is represented as the difference between the cost of goods sold (COGS) and the total revenue. A firm’s aggregate money within a specific financial timeline is its revenue.
Remember, COGS or cost of goods sold refers to the cost of production and manufacturing of the goods. On the other hand, revenue is often listed as net sales especially if it includes discounts and refunds from a returned good.
The formula of gross profit:
Gross Profit = Revenue – Cost of Goods Sold (COGS)
B. Example calculation
The primary formula to calculate a company’s gross profit involves the subtraction of the costs of goods sold and its revenue. Suppose Company X has a total revenue of $20,000 and a cost of goods sold or COGS of $1500; then the gross profit of Company X is calculated as follows:
$20,000 (Revenue) – $1500 (COGS) = $18500 (gross profit).
C. Importance
Gross profit plays a crucial role in improving the proficiency of the production. It is the difference between net sales and the cost of net sales. However, gross profit can be specifically important for a product-selling business instead of a service-selling business. The formula of gross profit is used to assess your business’s efficiency in using variable expenses such as supplies, raw materials, and labor.
II. What is net profit?
Usually, net profit refers to the amount of money your business makes after subtracting all operating costs, interests, and taxes over a given time frame.
A. Definition and formula
Net profit is the actual assessment of business earnings. It deducts all expenses, including taxes, interest, operating costs, and more, from the gross profit of the company.
The net profit formula goes as follows:
Net Profit = Gross Profit – Operating Expenses – Taxes – Interest – Other Expenses.
B. Example calculation
With a practical example of net profit calculation, you will understand this financial metric more clearly. For example, imagine company ABC has a gross profit of $18,500. Its operating cost is 1,000, tax is 1,500, and Other expenses subtotal up to 4,000. Then the net profit of ABC company will be:
$18,500 (gross profit) – $1000 (operation cost) – $1500 (tax) – $4000 (other expenses)
= $12,000 (net profit).
C. Importance
Unlike gross profit, net profit works to evaluate the actual earnings and sales profit of a business. Net profit subtracts all business expenses, including operational cost, tax and fees, and other related expenses from gross profit to get the actual profit within a specific financial timeframe. Therefore, it gives a comprehensive idea of a business’s overall efficiency or profitability.
Read More: What is Net Profit?
III. Key differences between gross and net profit
Now that we have understood what is the gross profit and net profit of a business, we will move forward to explore the key differences between these two financial metrics.
A. Scope of calculation
One of the primary aspects where gross profit and net profit calculation differ from each other is the scope of calculation. While gross profit primarily focuses on evaluating the cost of production of a company, net profit considers all operational costs/expenses and financial obligations of the company within a specific financial timeframe.
B. Purpose
Another aspect where gross and net profit differ from each other is the purpose of each calculation. Gross profit concentrates on evaluating the profitability of core operations as a result, it evaluates the overall financial health of the company. On the other hand, net profit is calculated by subtracting all business expenses, taxes, and interests from gross profit to evaluate the true efficiency of the business.
C. Financial statements
Lastly, gross profit and net profit are also used differently for financial statements. In the company’s financial statement, gross profit reports the total cost of goods sold subtracted from the total revenue of the company. On the other hand, the net profit of a company’s financial statement indicates the original sales value by subtracting operational expenses, taxes, interests, and other expenses from gross profit.
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IV. Examples and analysis
When learning about the differences between net profit and gross profit, looking at a few examples and analyses can be quite helpful.
A. High gross profit but low net profit
Gross profit refers to business revenue before subtracting the production and manufacturing costs. On the other hand, net profit is gross profit minus all operational and non-operational costs of the business. Therefore, higher gross profit with low net profit can cause several complications, as the net profit metric reflects a more realistic representation of your company’s finances than the gross profit metric.
B. High gross and net profit
Having a high gross profit and net profit ratio can have multiple benefits for a business. Gross profit refers to overall financial health, while net profit indicates the more realistic image of your company’s profit margins. Therefore, having higher gross and net profits is a great indicator that your business is efficient in generating good profit in business. This comparison can be a great tool to help investors in planning their strategic moves in investment.
V. Improving profit metrics
You must focus on enhancing your business’s gross and net profit metrics to improve your business efficiency and attract more investors.
A. Enhancing gross profit
Here are some effective strategies to enhance gross profit by reducing COGS and improving pricing:
● Negotiate better pricing with the suppliers
● Try to reduce waste
● Focus on improving production efficiency
● Find low-cost raw materials
● Automate production and operational tasks.
● Investigate offshore manufacturers to reduce COGS
● Observe market demand and improve your production quality and quantity.
B. Enhancing net profit
Like gross profit, enhancing net profit is also essential to increase your business efficiency. Here are several ways to enhance net profit:
● Reduce utility costs. Utility costs are a major component of operational costs that reduce your net profit ratio.
● You should also consider lowering your insurance premium costs, as higher insurance premiums fall under business expenses and reduce your net profit.
● Automating business procedures can be a great way to reduce labor costs and increase the net profit of your business.
● Focus on increasing your sales revenue and develop strategies to increase your sales revenue.
VII. Conclusion
Understanding the difference between gross and net profit is essential for both investors and companies. But before that, you should understand them individually.
A. Summary of key points
Gross and net profit are both essential financial metrics in business or a company’s financial health. Both companies and investors use these financial metrics to evaluate a company’s efficiency in generating profit. Gross profit refers to the business revenue before subtracting the production and manufacturing cost, and net profit represents the actual business profit after subtracting operational and non-operational expenses from gross profit.
B. Final thoughts
Although gross profit and net profit are inherently different, they both serve as essential financial metrics for assessing a business’s efficiency and profitability. So, you must learn to use gross profit and net profit calculations for the financial analysis of any business. Remember, gross profit and net profit are important in analyzing a company’s profit margin, and when you use them properly,y you can evaluate a business’s financial health and efficiency to generate profit accurately.
FAQs
1. What is the main difference between gross profit and net profit?
The main difference between gross profit and net profit is their functions. Gross profit indicates the rough profit of an organization. On the other hand, net profit indicates the actual earnings of a business.
2. What is the difference between net and gross?
In finance, gross means the total amount of earnings (subtracting manufacturing cost), and net means the amount left after deducting all the expenses.
3. How do you calculate gross profit to net profit?
Here is the formula to calculate net profit using gross profit:
Gross profit – All expenses = Net profit
4. What is an example of gross profit?
Here is an example of gross profit:
Suppose a company’s revenue after a financial year is $300 million. Its COGS, or cost of goods sold, stands at $200 million. Then the company’s gross profit is $100 million.
