Calculating your company’s profits shows you how much money your business brings in and helps you compare results from one accounting period to the next. But which types of profit numbers should you track: gross profit or net profit?
Here’s what you need to know.
Gross profit vs. net profit
Profit is a measure of your company’s earnings. The difference between gross profit and net profit is the kinds of business expenses you subtract from those earnings.
Gross profit = Net Sales – Cost of Goods Sold
For example, let’s say Elegant Eyewear, a retailer of sunglasses and prescription glasses, had gross income of $400,000 for the year. During that same year, customers returned $15,000 of merchandise. Elegant Eyewear also had cost of goods sold of $150,000.
For the year in question, Elegant Eyewear’s gross profit would be: net sales of $385,000 ($400,000 in gross sales minus $15,0000 of returns) minus its cost of goods sold of $150,000 = gross profit of $235,000.
Net profit is your company’s net sales minus all business expenses. Those expenses include COGS; selling, general and administrative (SG&A) expenses, and all non-operating expenses, such as interest, income taxes, and gains and losses from selling equipment.
The formula for net profit is:
Net Profit = Gross Profit - Expenses
Returning to our Elegant Eyewear example, say the company had SG&A expenses of $50,000 and interest expense of $2,000.
The company’s net profit would be: gross profit of $235,000 minus $50,000 of SG&A expenses, minus $2,000 of interest expense = net profit of $183,000.
Gross profit and net profit on the financial statements
Both gross profit and net profit can be found on your company’s income statement. Gross profit appears near the top of your income statement, just under revenues and COGS. Net profit is typically the last line of your income statement – that’s why net profit is sometimes referred to as the company’s “bottom line.”
To illustrate, here’s a sample income statement for Elegant Eyewear, showing both gross profit and net profit.
Gross profit vs. net profit: why it matters
Maybe you’re wondering, “why not just pay attention to the company’s bottom line?” While keeping an eye on net income is always a good idea, it doesn’t tell you everything you need to know about your company’s profitability.
If your company is struggling to stay afloat, looking at both of these profit figures can help you pinpoint the source of your troubles.
For example, if your manufacturing business has a high gross profit, but a low net profit, you know your issue doesn’t stem from paying too much for direct labor and raw materials or pricing your product too low.
You may need to take a closer look at your administrative expenses and non-operating expenses and cut costs there to improve results. Maybe you could negotiate with your landlord to reduce rent expense or refinance a loan to lower your interest expense.
On the other hand, if your gross profit is too low, you’ll have trouble covering your other expenses no matter how much you cut back. You may need to raise prices or look for ways to reduce your cost of sales.