Difference between gross profit and net profit


Learning objective:
What is the Difference between gross profit and net profit?

Definitions and meanings:

Gross Profit

Gross profit is the excess revenue that is left with the business after recovering the total costs spent on the production or purchase of the goods sold. It is computed either as a part of income statement or by preparing a separate trading account. In accounting and finance, the cost incurred on the purchase or manufacture of goods sold during a specific period of time is termed as cost of goods sold (COGS).

Mathematically, the cost of goods sold (COGS) can be calculated as follows:

COGS formula for a trading company:

COGS = Opening stock + Purchases – Closing stock

COGS formula for manufacturing company:

COGS = Opening stock + Cost of goods manufactured – Closing stock

Gross profit is a line item reported on the income statement and can be calculated through the following formula:

Gross Profit = Revenue – Cost of Goods Sold

Gross profit can also be defined as the profit earned by the company before deduction of operating expenses, interest expenses and income tax expense. It reflects how effectively the direct materials and direct labor and manufacturing overhead were managed and utilized during the production process.

Gross profit plays an important role in analyzing the trading and operational efficiencies of a company which, in turn, assists in making major decisions regarding prices, usage of inputs and other direct expenses. It is a vital indicator that decides whether a product or service is successfully being sold or not since it only reflects the profit earned by trading of goods.

The gross profit margin is a profitability ratio that helps in financial analysis of the company. It can be calculated through the following formula:

Gross Profit Margin = (Gross Profit/Revenue) × 100

It assists in comparing the progress of companies in the same industry. A company with a higher gross profit margin has an upper hand in the industry since it is paying less for direct costs as compared to other companies and can charge a higher price as well.

Net Profit

Net profit is the crux of an income statement. In fact, the income statement is prepared to calculate the net profitability of the business i.e. gross profit less operating expense, interest expense and tax expense. It can be defined as the “gain” you are left with after paying off all the costs incurred to generate revenue for the relevant period of time.

Net profit, also known as net income or bottom line, can be calculated through the following formula:

Net Profit = Gross Profit – Expense

It is one of the most crucial instruments of weighing a company’s financial performance. Since it is the main source of income for the stockholders, the net profit is one of the main elements analyzed by investors in deciding whether to invest in the company or not.

The Net profit margin is a financial analysis profitability ratio that can be calculated through the following formula:

Net profit margin = (Net profit/Revenue) × 100

It helps us compare the net profitability of company to other similar businesses in the industry and also gives an estimate of the expected net income in the particular market.

Net profit is also a major indicator of a company’s credit trustworthiness. Creditors like individuals, firms and financial institutions usually analyze the net profit figure to get an understanding of how suitable a company is for a loan.

Difference between gross profit and net profit

Even though both the terms represent a company’s gain by selling a commodity or service, they both have various differences that we are going to mention below:

1. Expenses involved in computations

Gross profit is revenue less cost of goods sold. Cost of goods sold includes expenses only that were incurred in producing/purchasing the goods. Net profit, on the other hand, is revenue less cost of goods sold less all other expenses. In order to calculate net profit, you need to know gross profit from which operating expenses, interest and taxes are deducted.

Purpose and requirement

Gross profit and net profit both are line items that accounting standards guide you to report on the entity’s income statement. Gross profit is not the ultimate figure of income statement whereas net profit is the ultimatum of income statement for which all the line items have been reported. Format of an income statement is shown below:

$
Revenue xxx
Less: Cost of goods sold (xxx)
Gross Profit xxx
Less: Operating Expense (xxx)
Less: Interest Expense (xxx)
Less: Tax Expense (xxx)
Net Profit xxx

Formulas and computations

Formula for calculating gross profit is:

Gross profit = Revenue – Cost of Goods Sold

whereas formula for calculating net profit is:

Net profit = Gross profit – (Operating Expense + Interest expenses + Income tax expense)

Nature of expenses involved

Cost of goods sold subtracted to calculate gross profit includes direct costs like purchase price, commission, direct material, freight charges manufacturing overhead and labor etc. whereas total expenses deducted to calculate net profit includes indirect or operating expenses like depreciation, wages, insurance, marketing and administrative expenses, office supplies and rent expenses etc.

Uses

Gross profit assists the management of company in making important decisions and also helps in effectively managing the manufacturing costs such as direct materials, direct labor and manufacturing overhead whereas net profit assists third parties like investors, creditors and other stakeholders to make decisions about their investment in the company.

Balance on accounts

Gross Profit has a credit balance on the trading account whereas net profit that has a credit balance on profit and loss account.

Measure of evaluation

Gross Profit is a better measure for assessing the progress of the company whereas net profit exhibits the profitability of the company.

Gross Profit versus Net profit – tabular comparison:

Gross Profit vs Net Profit
Definition
Excess of revenue over cost of goods sold i.e. manufacturing costs, purchase price, carriage inwards and outwards, commission etc. Excess of revenue over cost of goods sold and total expenses such as interest, tax and operating expenses (rent, utilities, depreciation).
Purpose
Assess the progress of business and how effectively the manufacturing cost is being managed or minimized. It gives a rough estimate of profit that can be earned in the market. Assess the profitability of business indicating earnings that the shareholders will receive annually which in turn evaluates the potential a company has.
Formula
Revenue – Cost of goods sold Gross profit – Total expenses
Credit balance
Trading account Profit and loss account
Reliable measure
It is not a true profit and only reflects profit after deduction of manufacturing costs ignoring all operating expenses that are incurred by the company. This makes it an unrealistic measure of profitability. Net profit is the true profit of company after reducing all expenses including cost of goods sold, operating expenses, interest expenses and tax expenses. It accounts for every revenue expenditure incurred during a period of time to generate the relevant revenue and hence is a realistic measure of profitability.

Conclusion:

Both, gross profit and net profit are important measures used in financial analysis of the company. These two are so important that the obligatory income statement that needs to be prepared annually is incomplete without them. However, when it comes to making important decisions and over all analysis of the company, net profit is just a bit more important than the gross profit.

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