Gross profit and net profit are both valid accounting words, and neither is superior to the other. However, when running a small business, it’s critical to remember the distinctions between these two notions.
The difference between the money you make from selling items and how much those products cost you is your gross profit. It doesn’t include some expenses that would normally be deducted from gross profit to get at net profit. Each word reveals information about your company that you should be aware of.
Calculating Gross Profit
You sell a widget for ten dollars. The widget will set you back $4. The formula for calculating your gross profit is as follows: you start with $10 and remove $4 to get $6. Your gross profit is $6. The theory behind this is as follows: gross profit equals revenue minus the cost of goods sold. The abbreviation COGS is frequently used to denote the cost of goods sold.
The widget sale mentioned here is correct – the gross profit is $6 – but it’s oversimplified. Consider the case when you didn’t purchase the widget. You made it yourself in your shop. Let’s say the materials you used to manufacture the widget cost you $1 and you sold it for $10. So, what’s your gross profit? $9? No, because you paid money to produce the widget, which is included in the cost of goods sold (COGS). You’d also have to factor in the hourly cost of labor to build the widget, as well as any sales commissions and credit card fees you paid to sell the widget.
What has Included in the Cost of Goods Sold?
So, where does it leave your rent? That, too, is a cost. You might be startled to hear that your rent is not deductible. The reason you don’t is due to the fundamental distinction between COGS-included expenditures and other business expenses that aren’t.
Any costs that vary with production or sales are included in the COGS. However, fixed costs are not included, such as rent, which remains the same whether your production line is running 60 hours a week or not at all.
Direct costs, not indirect costs, are used to calculate gross profit.
To summarise, gross profit is money from sales (or service – whatever your customers pay you for) less the direct costs of purchasing, making, selling, or transporting the goods to your client. Certain fixed costs, such as rent, are always excluded.
Gross Profit Factors in Direct Costs, Not Indirect Costs
Gross profit minus fixed costs equal net profit. To calculate net profit, start with your gross profit and deduct your fixed costs, which include the following:
Determining Net Profit
Employee salaries: they are fixed costs because, presumably, salaried personnel is paid the same amount each month regardless of how many widgets you sell – for example, a salaried accountant.
Taxes on real estate. Because, regardless of how many widgets you’ve sold, these are the same.
Utilities are a type of service. While it’s true that your electricity expenses, for example, may climb as a result of output, most accountants believe that because these costs are mostly set, they should be included in fixed costs.
Insurance is a term that is used to describe the
Professional fees, such as those paid to lawyers or CPAs.
Depreciation and Amortization Both of these charges are meant to indicate asset depreciation over time. Amortization is the phrase used to describe the slow loss of value of intangible assets, such as a medication patent or a patent on a new type of faucet; depreciation is the phrase used to describe the steady loss of value of physical assets, such as a business car or industrial machinery.
Why You Need Both Net and Gross Profit Calculations?
Although gross profit may not be your “actual” profit, you must calculate it to keep track of how your firm is going. First, net profit is calculated by subtracting these additional fixed expenses from gross profit. But, more crucially, gross profit provides you with critical information about how effectively your company is performing.
Your gross earnings, for example, maybe increasing, but your net earnings are declining. Is that a terrible thing? It’s possible, but it’s not a given. If your sales are continuously increasing, you may need to relocate to larger quarters at some point. This will result in a higher rent as well as all of the associated moving expenditures.
The net profit will most likely take a brief decrease as a result. The gross profit, which reflects your expanding sales, is the metric that informs you how well you’re doing in this case. Some charges, such as your relocation fees, which you have already paid, will no longer pull down net profit in the sales period that follows the period in which you made your relocation. Although the higher rent on your new quarters persists, the larger quarters allow you to raise production, even more, resulting in higher gross profits and, eventually, higher net profits.
The Net Profit May Point to Business Problems
In some cases, on the other hand, the net profit may reveal the true storey. For example, if your sales are rising slowly but your fixed costs are rising faster, the result will be a drop in net profit, indicating a real problem that can be solved by increasing sales at a faster rate, doing something to contain your fixed costs or a combination of the two.
Profit Vs. Gross Profit
To thrive and be worth its owners’ time and effort, any firm must be profitable. However, there are several ways to calculate profit, both in real dollars and in percentages, and a business owner must know which formulas to employ to demonstrate his true returns.
When a small firm calculates profit, the term “gross profit” is most usually used. It is the sale price of an item or service, minus the cost of providing that service. If a company buys or manufactures a widget for $1 and subsequently sells it for $3, it has made a $2 profit. If the widget must be sent at the company’s expense, the cost is taken from gross profit.
The amortized cost of all other business expenses divided by the number of sales is the difference between gross profit and net profit. For instance, if a company sells 100 widgets in a day, its gross profit is $200. If, on the other hand, an employee is paid $10 per hour for eight hours of work selling these widgets, the net profit is reduced to $120. When rent, utilities, and other expenses are factored in, a company’s gross profit may appear to be positive on paper, but net costs result in a loss.
Profit is computed in one of two ways: as real cash increments or as a proportion of costs. The widget business sells at a $2 markup above its $1 cost, resulting in a 200 percent increase in gross margin. When comparing different enterprises in the same category, margin comes in handy.
The passage of time can have an impact on profitability. If a company offers perishable goods, those expenses must be factored in as well. For instance, a company may have 1,000 widgets in stock, but 200 of those widgets will be out of style in three months and will not be able to be sold. The gross profit on the remaining 800 products will be the same, but the cost of the remaining 200 products will have to be factored into the net calculations.
In running a business, both gross profit and net profit have a place. Because many organizations operate on a regular markup margin for their sales, gross profit should be taken into account when pricing an item. Only those calculations can accurately indicate how net expenses amortize across all gross earnings, hence net profit should be considered when adjusting prices over time against actual sales.