To manage the financial health of your business, you need to have a clear picture of your gross profit vs net profit. They are both terms that are similar, but it is imperative to learn the distinction between gross profit and net profit so that you can make effective strategic decisions, such as how to price your services or how to take care of overhead. This guide will also take you through what each of the metrics is, how to calculate them, and why they are vital to your success.
The fundamental distinction comes down to the expenses you subtract from your revenue. We’ll show you precisely what gross profit (your revenue after direct costs) and net profit (your true bottom line after all expenses) are.
What is Gross Profit? The Foundation of Profitability
Gross profit refers to the amount of money earned by a business after it has been able to pay off expenses that are directly linked to the production and delivery of its products or services. Basically, it reflects your company’s efficiency in terms of raw materials and direct labor turnover into finished products or services.
The key to understanding what is gross profit is recognizing that it only includes the Cost of Goods Sold (COGS). COGS encompasses direct expenses that fluctuate with production volume. For instance, these costs include:
- Raw materials and supplies.
- Direct labor costs, including the salary of factory floor employees.
- Production equipment costs and utilities for the production site.
- Shipping costs for getting products ready for sale.
Consequently, gross profit is often called gross income. It is a primary indicator of your core operational business model’s health, providing the initial pool of cash that must cover all other operating expenses, interest, and taxes.
Calculating Your Gross Profit
Calculating your gross profit is the essential first step in financial analysis. The gross profit and net profit formula begins right here.
The Gross Profit Formula
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Calculation Guide
To calculate this, you follow these steps:
- Determine Revenue (Net Sales): It is the total receivable money on account of the sales of goods or services within the given time frame, less the amount of returns or allowances on sales.
- Calculate Cost of Goods Sold (COGS): Add up all the direct costs that you incurred to manufacture the goods or services sold, and add them up to calculate the Cost of Goods Sold.
- Subtract COGS from Revenue: The resulting number is gross profit.
What is Net Profit? The True Bottom Line
The bottom line or net profit, also called net income, is the cash that is remaining in your business once all the expenses are subtracted from the total revenue. In particular, when gross profit is operational efficiency, net profit is the ultimate measure of all financial success.
During its 2024 fiscal year, we have witnessed a company record revenue of $43.45 billion, with a cost of production of 33.85 billion. This puts the company, as represented in the third line of its income statement, with a gross profit of 9.6 billion.
What is net profit? It is your profits once you have calculated the direct costs (COGS) as well as all indirect costs, which are:
- Operating Expenses (OpEx): Salaries (non-production staff), rent, utilities, insurance, marketing, and general administrative expenses.
- Non-Operating Expenses: Interest on loans, losses from selling assets, and other non-core expenses.
- Taxes: Income taxes to the government.
Finally, a positive net profit is the amount you are able to keep as growth (reinvestment) or distribute to owners and shareholders.
Net Profit Formula and Calculation
Once you have calculated your gross profit, finding the net profit is straightforward.
The Net Profit Formula
Net Profit = Gross Profit – Operating Expense – Other Expenses – Interest – Taxes.
You can use the following version that is less complicated:
Net Profit = Total Revenue – All Expenses
Calculation Guide
- Begin with Gross Profit: Start with the figure that you have determined in the previous section.
- Deduct Operating Expenses: Subtract the fixed costs required to run the business (rent, salaries, utility bills, etc.). Importantly, this includes costs related to client management, lead management, and proposal management software.
- Deduct Non-Operating Costs, Interest, and Taxes: This is where all the remaining costs that are not directly related to production are subtracted. The last figure is the net profit.
The Core Difference Between Gross Profit and Net Profit
The difference between gross profit and net profit is the inclusion of operating expenses. Think of gross profit as the success of your product or service pricing strategy, whereas net profit reflects the effectiveness of your entire business spending and cost control.
| Aspect | Gross Profit (Gross Income) | Net Profit (Net Income) |
|---|---|---|
| Focus | Efficiency of production and pricing. | Overall financial health and bottom-line viability. |
| Formula | Revenue – Cost of Goods Sold (COGS) | Gross Profit – All Other Expenses |
| Expenses Included | Only direct costs (COGS) are materials and direct labor. | All the direct and indirect expenses: COGS, rent, salaries, taxes, interest, marketing, and administration. |
| Position on Income Statement | The first profit calculation (the “Top Line”) | The final profit calculation (the “Bottom Line”) |
| Key Insight | Does the price of your product cover its direct costs? | Is the business making money after paying absolutely all its bills? |
Therefore, if your gross profit is high but your net profit is low, you have an excellent core product margin but poor control over overhead, such as high administrative costs. On the other hand, low gross profit indicates that there is either a pricing or COGS issue, and therefore, it is almost impossible to attain a good net profit. Finally, to be actually successful, you must have an excellent gross profit and net profit margin.
Gross Profit and Net Profit Example: Alpha Solutions
Let’s use a simplified example of “Alpha Solutions,” a specialized consulting firm, to illustrate the gross vs net profit calculation for one quarter.
| Item | Amount |
|---|---|
| Total Revenue from Projects | 100,000r |
| Cost of Goods Sold (COGS): | |
| Direct Consultant Labor (Billable Hours) | 25,000 |
| Client-Specific Software Licenses | 5,000 |
| Total COGS | 30,000 |
| Operating Expenses (OpEx): | |
| Office Rent & Utilities | 8,000 |
| Administrative Salaries (Non-Billable) | 15,000 |
| Marketing & Lead Management Software | 2,000 |
| Total OpEx | 25,000 |
| Other Expenses: | |
| Interest Expense on Loan | 1,000 |
| Taxes | 10,000 |
Step 1: Calculate Gross Profit
We use the gross profit formula:
Gross Profit = Revenue – COGS
Gross Profit = 100,000 – 30,000 = 70,000
A gross profit of 70,000 indicates that Alpha Solutions is effective in providing its services to its direct expenses. We simply need to subtract the operating expenses to make the difference between the gross profit and net profit obvious.
Step 2: Calculate Net Profit
We use the net profit formula:
Net Profit = Gross Profit – OpEx- Other Expenses- Taxes.
Net Profit = 70,000 – 25,000 – 1,000 – 10,000 = 34,000
The amount of money that Alpha Solutions made after deducting all the costs is the net profit of 34,000. Consequently, this net profit can be reinvested in the company, perhaps to purchase better client management tools or expand their team.
Conclusion
Understanding gross profit vs net profit is more than just a bookkeeping exercise; instead, it serves as the foundation of strategic business management. The gross profit is your first indicator of product or service health. If it’s too low, you face a critical problem with either pricing or production cost control. This measure is critical to the effectiveness of your sales activities, especially when preparing invoices and estimates and controlling your costs of providing services.
Related Reads
- Sales Organization Structure: Types, Purpose & Hierarchy Explained
- What is Sales? Sales Meaning, Types, and Importance Explained (Guide)
- Sales Analysis Explained: A Complete Guide to Sales Data and Trends
- Inbound vs Outbound Sales | Difference, Meaning & Strategies Explained
- What is a Sales Plan? Process, Strategy & Templates Explained
- Inside Sales Explained: Meaning, Key Roles, and Responsibilities
- What is Return on Investment (ROI) and the ROI Calculation Formula?
- What is a Sales Budget? Complete Guide with Example and Process
- What is Sales Tracking and How Does it Work?
- What is Sales Support and Why Does it Matter Most for Business Growth
- What is Sales Data Analysis, and How to Perform it for Business Growth?
- What is Sales Methodologies and How to Choose the Right One for Your Business?
- What is a Sales Qualified Lead (SQL) and Why Does it Matter?
- Key Differences and Why They Matter in Sales & Marketing
- What is Sales Support and Why Does it Matter Most for Business Growth
Gross Profit vs Net Profit FAQs:
It indicates the financial feasibility and fundamental effectiveness of the pricing and manufacturing of a commodity or service preceding the overhead costs.
The bottom line figure is the one that gives the best estimation of the true overall financial health of a company as well as the actual cash left after all the expenses have been incurred.
A negative net profit (net loss) is an indicator that the overall cost of the business is more than the overall revenue, which requires an urgent reduction in the cost or an increase in sales.
The gross income is calculated by deducting the cost of goods sold (COGS) of 1/2 total revenue; the net profit is calculated by deducting all other operating and non-operating expenses from the gross profit.
Increase gross profit by increasing the prices or cutting the COGS, and increase net profit by managing overhead by increasing expense control and operational efficiencies.
