Gross profit vs net profit: a comprehensive guide for entrepreneurs

Gross and net profits are a must if you want to better understand your company’s profitability. In this article, we will compare gross profit vs. net profit and explain how they are calculated and why they are important for a business’s financial health and financial goals.  

What is gross profit?

A business gross profit refers to the funds your business earned over a specific period, excluding the cost of goods sold. You can find gross profit (aka gross income) on a company’s income statement.

Identifying the business’s gross profit allows companies to understand if they earn enough funds to keep up with their operational costs and make their business successful. Based on the company’s gross profit figures, a business owner is better aware of the pricing they should set for their products and possible changes in the overall strategy they need to undergo. 

How to calculate gross profit?

To calculate your gross profit formula, you need to subtract the cost of goods sold from the company’s revenue. 

The cost of goods sold (COGS) is the sum a company spends on producing its goods and/or services. The COGS usually consists of raw materials used for manufacturing, wages paid to employees, and some indirect costs. The cost of goods sold can be calculated using the cost of goods sold formula. 

Revenue is the sum of all money earned by a business from its operations and sales of goods and/or services. Note that some formulas for calculating gross profit use net sales instead of revenue. Net sales allow for a more precise calculation, as they represent revenue after deducting returns, allowances, and discounts.

Here’s an example of gross profit calculation: 

In August, company A’s revenue for its goods was 432,963 EUR. After deducting returns, allowances, and discounts from the revenue, its net sales went down to 421,100 EUR. Also, in August, the company spent 200,430 EUR on manufacturing its merchandise, which is its COGS. 

So, to calculate gross profit, do the following: 421,100 EUR (net sales) minus 200,430 EUR (COGS), which equals 220,670 EUR.  

What is net profit?

Net profit represents the funds a business is left with after its total expenses for a set period are deducted from its total revenue from the period. Note that net profit can sometimes be referred to as net income, as these are interchangeable terms. 

Net profit (net income) is necessary to determine how efficient and profitable the business is. Moreover, net profit allows for assessing a business’s financial health and the ability to generate profit. 

How to calculate net profit?

As mentioned, to calculate the net profit, you need two key metrics: total revenue and total expenses. 

Total revenue is the money and operating profit a company earns from its business activities (price per product unit, multiplied by the number of units sold) before the deduction of any expenses. Thus, it comes from products sold and other earnings made from interest, dividends, or royalties. 

Total expenses are what they are in the name – all the expenses a company had in a set period: COGS, operating expenses, interest expenses, income taxes, depreciation, overhead costs, and other expenses. 

Here’s an example of how to calculate a net profit:

In July, company A earned 136,000 EUR from selling its products, as well as 67,500 EUR from interest. Thus, its revenue is 203,500 EUR. At the same time, company A spent 68,000 EUR on manufacturing products and operating expenses and 79,000 EUR on labor costs and income tax. The total expenses are 147,000 EUR. 

The company’s net profit is total revenue (203,500 EUR) minus total expenses (147,000 EUR), which equals 56,500 EUR. 

Now that you know more about both, let’s compare gross profit vs. net profit.

Net profit vs gross profit: key differences

Gross and net profit differ, but determining both is important for a business. Let’s compare gross vs. net profit to learn the difference.

Points of comparison	Gross profit	Net profit
Formula components	You need revenue/net sales and COGS to calculate gross profits.	You need total revenue and total expenses to calculate net profit.
Impact on financial statements	Gross profit is used to determine the profit from core business operations and if they are effective.	Net profit is used to determine overall business profitability after all expenses have been deducted.
Role in business decision-making	Gross profit numbers allow for making decisions about pricing, sales strategies, and production. It helps understand direct costs and improve profit margins.	Net profit numbers help with overall financial planning, such as budgeting, investments, dividends, and reducing costs.
Implications for taxation	Gross profit is not directly linked to taxes but can help make decisions related to tax optimization.	The higher the net profit is, the higher the taxes will be.
Implications for investment	A high, stable gross profit can signal to the investors that the company is worthy of investing in.	Net profits are important, as they show the return on investment after all expenses.

Importance of gross profit and net profit

After comparing gross profit vs. net profit, we want to explain why they are important:

1. They help assess your company’s performance. Gross profit shows how well a business makes money and operating profit from sales after direct costs. Net profit shows overall financial health by including all business expenses.
2. They allow for determining which costs can be cut. Gross profit helps find ways to cut direct costs, while net profit points out where broader expenses need control.
3. They show how well you manage your company. Gross profit and net profit show you core profitability and long-term financial stability, respectively. 
4. Gross profit and net profit keep investors informed. Investors use these metrics to assess how successful the business is and if it’s worth investing in.  

How to improve gross profit margin

A gross profit margin is a percentage of revenue that exceeds the cost of goods sold and helps businesses determine if their manufacturing efforts and sales are successful.

To calculate your gross profit margin, you need to divide your gross profit by net sales and multiply the number by 100. 

Here’s how you can improve your gross profit margin if the gross profit percentage is low:

• Consider reducing the costs of manufacturing products after reviewing your income statements: improve your inventory, switch to other, cheaper materials, and negotiate for lower raw material costs with the manufacturer;
• Optimize your production: you can achieve a positive gross profit margin by investing in technology that will speed up the manufacturing process, reduce operating expenses, and train your employees to work more efficiently;
• Promote more expensive products: focus your marketing efforts on higher-margin products or services to increase overall gross profit;
• Consider pricing changes: another way to improve your gross profit margin is increasing prices for some of your products or services or bundling products;
• Improve your products: make sure there are as few returns as possible by leveling up the quality control for a better gross margin;
• Decrease the number of discounts: want to have a good gross profit margin? Reevaluate your discounts and remove unnecessary ones.

How to improve net profit margin

Net profit margin is a percentage of revenue that remains as profit after all expenses have been deducted and shows how profitable the company is. 

To calculate your company’s net profit margin, you need to divide your net profit by total revenue and multiply the number by 100. 

To improve the net profit percentage, consider the following steps:

• Review your operational costs: you can cut some operating expenses and production costs to improve the net profit margin, such as administrative costs or office supplies;
• Manage your debts: having debts is bad for the company – refinance high-interest debt and pay off loans as soon as you’re able to;
• Change prices: a good net profit margin often relies on setting reasonable prices for your products and increasing some fixed costs if necessary;
• Revise your marketing strategy: focus on high-ROI marketing channels, reduce spending on ineffective campaigns, and use data analytics to target the right audience;
• Pay attention to customers: develop a strategy to retain your clients by focusing on loyalty problems;
• Try different revenue streams: to improve the net profit margin, consider adding more revenue streams by going into new markets and creating new products if you want to avoid lower profit margins.

Common mistakes to avoid

• You always need to include all your administrative expenses and other spending in calculations, carefully review the income statement to avoid skewing net profit and monitor cash flow. 
• Both gross and net profit margins need to be accounted for. Neglecting one of them will result in inaccurate reporting.
• A business owner should not only rely on short-term profit spikes or drops, but they can also be misleading. 

And, of course, one of the most common mistakes is partnering with a financial provider that cannot handle the tracking of high transaction volume. If you need help with that, we recommend Genome.

Our electronic money institution allows sending international and SEPA money transfers, as well as up to 3000 payments via the batch transfer feature. All these payments are tracked seamlessly inside the Genome app. 

Using financial tools and software

Never hesitate to use additional tools to track and analyze your gross and net profit. For instance:

• Accounting software and ERP systems for profit and total sales tracking;
• Financial dashboards for profit and key metrics visualization;
• Spreadsheet programs for manual total sales tracking and analysis; 
• Profitability analysis tools to monitor margins and identify profit drivers. 

Conclusion

Calculating and monitoring your net and gross profits is essential for understanding how a company’s profit changes under specific conditions. Navigating these metrics can improve your business income and grow your company. 

FAQs

How does gross profit affect pricing strategies?

Gross profit helps develop pricing strategies by allowing companies to determine the minimum price needed to cover operating costs and understand which strategies can be applied to generate revenue. 

What industries typically have high gross profit margins?

Usually, industries that have lower direct costs relative to their sales generate higher gross profit margins. These are software and technology, pharmaceuticals, financial institutions, luxury goods, and professional services.

Can a company be profitable with a negative net profit?

No, your business can’t be profitable while having a negative net profit because it spends more money on raw materials and manufacturing products than it earns from selling those, which results in a net loss. 

How often should businesses analyze their gross and net profits?

It is normal to analyze net and gross profits every month to keep up with the company’s financial health. 

What role do gross and net profits play in securing business loans?

Gross and net profits are used to evaluate the risks associated with a business. The better the numbers, the higher the chance for the loan.