Gross profit means revenue minus Cost of goods sold. Gross profit is the revenue derived from sale or service after deducting the direct cost associated with buying, manufacturing, selling or shipping the product to the customer. Certain fixed costs & rent is always excluded from the revenue. For ex – If you sold an item for £10 and it actually costs you £6. Then, the Gross profit will be £10-£6 = £4. In this example – we deduct the revenue (£10) from the cost of goods sold (£6) and calculated the gross profit (£4).
Therefore, Gross profit is basically a difference between revenue generated by a product or service and cost of producing it. Gross profit doesn’t account for other costs which are deducted to give net profit. For ex – Taxation, interest, payroll, other overheads etc. By not considering all these costs, it does not show you the true profit of your business. It only helps you in showing that how much growth your business has done in a particular period.
Net profit means Gross profit minus all indirect expenses. Net profit is the revenue derived from selling product or service after deducting all expenses including COGS. To calculate net profit, you have to deduct each and every cost you incurred for running a business in a particular year. It includes costs such as Utility bills, rent, marketing cost, distribution cost, salaries, car cost etc.
When you deduct all expenses from your total income, you will easily get the net profit. For ex – Suppose your total income is £60,000 and cost of running a business is £30,000. Net profit =? Net profit = Total income – Total business expenses or cost of running a business = £60,000 – £30,000 = £30,000
In net Profit, all expenses include general, selling & administrative as well as non-operating expenses. The list of expenses deducted to calculate net profit are given below –
- Utility bills
- Salary paid to employees
- Property tax
- Fees paid to professionals
- Depreciation etc.
The account prepared to calculate net profit or net loss is known as Profit & loss account. To understand the difference between Gross profit & Net profit more clearly, see the table below –
|Basis of Distinction||Gross Profit||Net Profit|
|Meaning||Gross profit means Revenue minus Cost of Goods sold||Net profit means Gross profit minus all indirect expenses|
|True Profit||It doesn’t show the true profit of the business||It shows the true profit of the business.|
|Account prepared||Trading account is prepared to calculate the Gross profit||Profit & loss account is prepared to calculate the Net profit|
|Balance||It shows the credit balance of the trading account||It shows the Credit balance of the Profit & loss account|
|Judgement||The growth of the business can be judged by comparing G.P with net sales||The profitability of the business can be measured by comparing the net profit with net sales.|
To access their performance, many businesses used profit margin calculations. It is also used as a key performance indicator to set targets. There are two different profit margins –
Gross profit Margin
Gross profit margin is calculated by dividing gross profit by revenue. For ex – ABC Ltd. Company has revenue of £200,000 with cost of sales given is £120,000. Calculate the gross profit margin?
Revenue (given) = £200,000 Cost of sales (given) = £120,000 Gross profit margin = Gross profit / Revenue Gross profit = Sales – COGS = £200,000 – £120,000 = £80,000 Gross profit margin = £80,000/£200,000
= 0.40 or 40%
Net Profit margin
Net profit margin is calculated by dividing net profit by revenue. It is a more accurate measure of business profitability as it shows true profit of your business. For ex – ABC Ltd. has a Gross profit of £200,000 with total expenses given is £120,000 & revenue is 300,000. Calculate the Net profit margin?
G.P (given) = £200,000 Total expenses = £120,000 Revenue = £300,000 Net profit margin = Net profit / Revenue Net Profit = Gross profit – total expenses = £200,000– £120,000= £80,000 Net profit = £80,000/£300,000 = 26.6%
Why you need both Net Profit & Gross Profit Calculation
Calculation of gross profit & net profit is very necessary for the business. Gross profit may not show you the real profit of your business but it should be calculated to know how much growth your business is doing. Gross profit provides you information that how much revenue you earned from a product or service after deducting all direct expenses from it. It also helps you in planning how you can take your business forward.
Sometimes, your gross profit may increase but your net profit goes on decreasing and you feel that this situation will impact your business badly but it is not necessary that it will impact. When your sales starts rising and in future you reached at the level, where you need to shift to the large quarters, it will incur high cost. Moving into large quarters will entail high rent and also other costs associated with it. As a result, you will see that there is a slight dip in the net profit. In that case, gross profit figure will tell you that how much growth your business is doing and it will reflect in the form of increased sales. After some time, the moving cost which you have already paid will stop putting down your net profit.
Higher rent on new quarters will remains the same but increase in production will increase the gross profit and finally results in rise of net profit again.
Net profit tells you the real story. If your sales are increasing slowly but fixed costs are increasing more rapidly, it will result in dropping of net profits. It can be resolved, if you will increase your sales at a faster rate by doing something.