Gross Profit vs. Net Profit: What’s the Difference?
By Anastasia Hinojosa
Updated September 30, 2021 | Published February 4, 2020
Updated September 30, 2021
Published February 4, 2020
Anastasia Hinojosa is an experienced financial accountant with degrees from Texas A&M-Corpus Christi and Columbia University. She has worked in the healthcare field for over ten years.
Gross profit and net profit are fundamental financial tools that aid in making important financial decisions that help a business reach its strategic goals. It is valuable to understand the difference between gross profit and net profit when analyzing a business's overall financial health. In this article, we explain the differences between gross profit and net profit and how to calculate each profit type with examples.
What is gross profit?
A business's gross profit is the total revenue minus the cost of making a product or providing a service. Gross profit is also referred to as gross income. Total revenue is the sales price of each item or service multiplied by how many of each item or service is sold. Gross profit can be calculated by subtracting the business's cost of goods sold from the total revenue. The cost of goods sold refers to the amount of money that is spent on the costs of producing products or providing services. However, calculating gross profit does not take additional expenses into account. For this reason, gross profit provides only a rough estimate of how much profit a business has actually made.
How to calculate gross profit
There are a few steps to calculating your gross profit. First, you will need to calculate the total amount of your earnings as well as the cost of selling your products or services. The following steps can help guide you through the formula:
Gross profit = Total revenue – Cost of goods sold (COGS)
1. Calculate your total earnings
Calculate your total earnings by adding all the revenue obtained through your sales during the time period you want to track. For example, you can add all credit and cash sales, online or offline sales and any earnings obtained through providing services or selling products. To calculate revenue, take the sales price of the item or service multiplied by the quantity sold. Add up all of this revenue.
2. Calculate the cost of selling your goods or services
Calculate cost of goods sold (COGS) by combining the total value of costs required to bring a product or service to market. Add up indirect and direct costs like labor and resources or supplies. COGS is a combination of trackable direct costs and allocated indirect costs like overhead. Each type of item or service may have its own associated COGS. For instance, if you own a bakery, the cost of ingredients and labor to produce a cookie will be different from the cost of ingredients and labor to make a cake.
3. Subtract the value of costs of goods sold from your revenue
After calculating your revenue and the total value of your costs of goods sold, use the formula (gross profit = revenue - COGS) to subtract the costs from the revenue. The resulting amount is your gross profit.
What is net profit?
Net profit refers to a business's total revenue after subtracting all interest; income and payroll taxes; and mortgage, utility or rent expenses. Net profit is the gross profit minus all other expenses. It is also referred to as net income (if a positive amount) or net loss (if a negative amount).
How to calculate net profit
You can calculate your net profit in a few simple steps after calculating your total gross revenue. First, you will need to calculate your gross profit and the expenses outside of the value of your cost of goods sold. The steps below outline how to calculate your net profit using the formula:
Net profit = Gross profit – Total expenses
1. Calculate your gross profit
To calculate your net profit, you must first know what your gross profit is. Gross profit equals Revenue minus COGS. After calculating your gross profit, you can calculate the rest of the formula.
2. Calculate your total expenses
After recording your gross profit, calculate your total expenses. These are the expenses outside of your costs of goods sold and will include expenses like income taxes, marketing, administrative costs, depreciation and other expenses that are not directly related to production costs.
3. Subtract expenses from your gross profit
Once you have all your calculations, you can use the formula (net profit = gross profit - expenses) to calculate your net profit. You can also simply subtract the value of all of your expenses from your gross revenue, and the results equal your net profit. If your revenue minus all expenses is negative, then it is a net loss.
Gross profit vs. net profit
The biggest difference between gross profit and net profit is the subtraction of expenses. While gross profit is the value of the revenue generated overall after only subtracting the cost of providing a product or service, the net profit describes the total amount a business keeps after all expenses are subtracted from the earnings. A company may use gross profit and net profit to evaluate its overall financial health and standing.
Knowing the difference between calculating gross profit and net profit can be essential in situations where a business is reviewing its financial performance. A business can use its net profit to determine whether it has incurred a loss or gained a profit. Gross profit can tell a company how much production costs are affecting sales revenue. High production costs will cause a significant difference between total revenue and gross profit.
The difference between gross and net profit also means a business can determine where its financial health stands. For instance, if you encounter a negative result in your net profit, it means your business has incurred a net loss. You can then use information from the data to make changes to marketing or sales strategies. Knowing that gross profit is the total value before all other expenses are deducted also means you can implement budgeting strategies to ensure your financial goals are met.
Read more: 6 Essential Accounting Skills
Examples of calculating gross profit and net profit
Gross profit and net profit are two factors in determining a business's overall financial status, and the following examples illustrate how a company would calculate both its gross profit and net profit.
For example: A small business, Cookie's Baked Creations, wants to calculate its gross profit for the quarter. The financial advisor uses the business's sales and expense records to calculate the business's revenue by totaling the sales amounts for the quarter. The business's revenue for the quarter is $42,500.
Then the financial advisor calculates the business's total cost of goods. After adding up the cost of materials, supplies and equipment, the business's resulting COGS equals $3,500 for the quarter. Since Cookie's Baked Creations uses ovens and stoves as well as employee labor in the production of their baked goods, their utility expense is also allocated to the cost of goods sold. This results in an additional $21,075 in COGS, which increases the total value to $24,575.
The financial advisor then calculates the business's gross profit by using the formula (gross profit = revenue - COGS) as follows:
(Gross profit = $42,500 - $24,575) = ($17,925)
So, Cookie's Baked Creations gross profit is $17,925 for the quarter.
Using the same example business, Cookie's Baked Creations further breaks down their financials to find the net profit. The financial advisor takes the gross profit and subtracts expenses like the business's rent, income and payroll taxes and other expenses. The business's expenses amount to $15,100 for the quarter.
The financial advisor uses the formula (net profit = gross profit - expenses) to calculate the business's net profit for the quarter:
(Net profit = $17,925 - $15,100) = $2,825
Cookie's Baked Creations nets a quarterly profit of $2,825. Assuming that the owner of Cookie's is an individual with only two employees, the owner might consider implementing strategies to increase revenue and cut costs. The owner can consider raising the sales prices, lowering the cost of goods sold or lowering other operating expenses.
Understanding gross profit and net profit is a key component to evaluating how to increase overall financial health.
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