Gross Profit vs. Net Income
Gross Profit vs. Net Income: What's the Difference?
In the course of running a business, you’re going to run into the accounting terms gross profit and net income. They both serve a distinct purpose, so it’s critical that you understand the differences between the two.
Put simply, gross profit is your net revenue minus the cost of goods sold. Net income is the gross profit minus operating expenses, interest expenses, and taxes (NI = GP - OE - IE - T).
But why do they matter, and how do you calculate gross profit and net income? To help you answer this and more, we’ll cover the following:
- Calculating gross profit
- Gross profit margins
- Calculating net profit margin
- Why both gross profit and net profit matter
Calculating Gross Profit
Gross profit is the profit your company makes after you’ve subtracted the direct costs associated with making and selling a product. Or, if you’re a service provider, it’s the direct costs associated with providing that service.
Your gross profit will always be listed on your company’s income statement. It’s calculated by taking your net revenue and subtracting the COGS (cost of goods sold).
To fully understand gross profit calculations, you need to know the differences between fixed and variable costs.
Fixed costs are static and predictable costs, including:
- Salaries and wages
- Payroll taxes and employee benefits
- Advertising, promotional, and sales expenses
Variable costs that change according to the amount of the product made or service provided, including:
- Direct materials and labor
- Any shipping costs
- Hosting expenses to deliver a software
- Costs for third-party software related to the delivered product
- Costs for implementation (consulting, data migration, training)
- Costs for customer support
Per Entrepreneur: “Variable expenses are recorded as cost of goods sold (COGS). Fixed expenses are counted as operating expenses (sometimes called selling and general administrative expenses [SG&A]).”
The COGS will differ according to what you’re selling. If it’s a product, like a smartphone, the COGS are related to the various inputs needed to make the phone. For software companies selling software-as-a-service (SaaS), COGS may include things like cloud hosting costs, customer support, and payment processing costs.
Using the gross profit formula: if you were to sell an item for $100 and it costs you $30 to make, the gross profit is $70. This is an important metric that tells you how much income you’ll make for each product sale before deducting for fixed costs.
Gross Profit Margins
Once you’ve discovered your gross profit, that number can then be used to calculate another important financial metric—gross profit margin.
The gross profit margin tells you how efficient your business is over time. On its own, gross profit doesn’t necessarily translate to success. You can have gross profits rise while the margins fall over time, which could cause problems over the long term.
Put simply, gross profit margin is gross profit divided by total revenue (GPM = GP/R), and then multiplied by 100 (to make it a percentage). Gross profit is always listed as a dollar amount, whereas gross profit margin is a percentage. Armed with that percentage, you can then measure your profitability patterns over time.
If you notice that margins are decreasing, you have two options to improve them: increase prices or decrease COGS.
Calculating Net Income
Net income is what your business earns after operating expenses, interest expenses, and taxes are subtracted off gross profit. Per CFI, it’s “the amount of accounting profit a company has left over after paying off all its expenses. Net income is found by taking total sales revenue and subtracting COGS, SG&A, depreciation, and amortization, interest expense, taxes, and any other expenses.”
Typically, it is the final line item on an income statement; although some income statements will give it its own section. Depending on your company it may be listed as the net income, net profit, or net earnings.
For a service company, calculating net income involves subtracting the following expenses where applicable.
- Equipment (including repair and maintenance)
- Professional services (lawyers, CPAs, etc.)
- Employee meals
Sales and marketing-related expenses
- Advertising and sales materials
- Direct mail costs
- Travel and entertainment (should there be any)
- Payroll tax expenses
- Stock based compensation
- Sales commissions
- Employee benefits (health insurance, 401k, pension plans)
Why Both Gross Profit and Net Income Matter
When studying your financial health, you can’t simply depend on one financial metric. Left to its own merits, any number can be deceiving. It takes several figures to provide context and flesh out your financial situation. As such gross profit and net income are both crucial line items on a P&L or income statement. By calculating these numbers, you’ll be able to see where you can cut business expenses or improve your bottom line.
Investors and lenders need to see all of these important numbers to have a gauge on your financial well-being. You can’t simply show them gross profits. Nor can you just provide net income. While these are important metrics, they don’t tell the whole story.
Gross profit tells you how much income you make from each product sale before subtracting fixed costs. By also providing net income, it becomes much easier to tell how much cash you're marking (or burning) for any given period of time.
Together, these metrics represent actionable information your team can leverage to make improvements. And for investors or lenders, it gives them a clearer understanding of the overall strength of the company, as well as the direction it’s heading.
Ramp: Your Partner in Maximizing Gross Profit and Net Income
If you want to implement a financial management strategy for your business, it starts by taking the time to understand the finance 101 terms (like gross profit vs. net income) and your business’ underlying financials. At Ramp, our mission is to promote this financial literacy while also providing solutions that help you strengthen your business.
How do we do that?
By providing you with the only corporate card that helps you save. With Ramp’s integrated operating expense management platform, you can better control your operating expenses. It gives you:
- Greater visibility into where you might be overspending
- Increased control over how much and where you’re spending
- Ability to cut down on fixed and variable expenses by eliminating redundant spending
- Automatic 1.5% cash back on every purchase
Armed with our automated systems, you can maximize both your gross profit and net income.
Entrepreneur. How to Calculate Gross Profit. https://www.entrepreneur.com/article/226158
Corporate Finance Institute. Net Income. https://corporatefinanceinstitute.com/resources/knowledge/accounting/what-is-net-income/