Profit is, quite obviously, important to consider as a business owner. Comparing current profits to profits from previous accounting periods gives companies a better understanding of growth and success. To truly understand and monitor the financial health of a business, it's important to understand two key types of profits: gross profit and net profit.
Gross profit, also known as gross income, is the profit a business makes after subtracting its costs from its total revenue. Subtracting your cost of goods sold from total sales will yield gross profit.
Note: when calculating total sales, it's important that to include all goods sold in the period that you’re evaluating BUT to omit the sales of any fixed assets (e.g. manufacturing equipment).
Gross profit helps you measure how efficiently you’re using your resources (e.g. labor and supplies) to create goods and/or services. It’s important to have an accurate view of gross profit when you want to understand the profitability, future state, and financial performance of a business.
Gross profit also helps in understanding the costs that will likely need to be incurred in order to generate revenue. For example, when the cost of goods sold increases, your gross profit decreases. In such a situation, you won’t have as much money to cover expenses (either those that are fixed or necessary to keep the business running smoothly).
Net profit refers to the amount of money a business earns after accounting for or subtracting, all the operating, interest, and tax expenses over a given accounting period.
In order to determine net profit, you need to know your gross profit.
Net profit, like gross profit, is quite important: it’s another indicator of a business's financial health (e.g. can a business make more than it spends?).
Profit and profitability are not the same thing. Profit is simply a calculation of your revenue minus your expenses, while profitability is the ratio between your profit and your revenue. Why does that matter? Well, net profit tells you about profitability, hence the importance of understanding the difference.
To extrapolate further, net profit indicates more about cash-on-hand than gross profit does. Oftentimes, investors or advisors will look at net profit instead of gross profit for this very reason. This, however, doesn’t mean that gross profit is unimportant. Gross profit is still important in determining how you can minimize your expenses and/or optimize your pricing strategy (e.g. raising prices). The two serve their own purposes and are valuable to analyze in conjunction with one another as, for example, if your gross profit is lower than your net profit, it’s a solid indication that you need to explore ways to reduce your overall expenditure.
The calculations for gross profit and net profit are quite simple.
To calculate gross profit, subtract your cost of goods sold from your total revenue. A successful business will have a positive gross profit, which allows them to cover their expenses. Put simply:
Gross profit = Total revenue – Cost of goods sold
To calculate net profit, add your total operating expenses (including your interest and taxes) and subtract the value from your gross profit. A positive net profit means that businesses can pay themselves after paying off their expenses. If the value is negative, you have what’s referred to as a “net loss”. Put simply:
Net profit = Gross profit – Expenses