Introduction
Unless you are filthy rich with no shady deals under your belt and are completely secure, there is a high chance that you have experienced a sinking feeling. There is always a sinking feeling when you approach the billing counter, make a purchase and watch your balance drop. Be it the perfect green scarf or the bacon burger of your life, every single time you spend money and watch the bank send you a message of the deduction, or have the wallet get lighter, you most definitely experience a stab of loss – it could be a wrenching one or a tiny little slit but there is some pain. A little pain that’s caused by the expense.
Additionally, expenses can be tiresome. And calculating them is only a vengeful act of fate to show you that your fun times sometimes (most times) come at a cost. Nothing is free in this world. Everything comes at a price. Unless you count air and water. Even then, pure breathable air and safe drinking water are available in only select places on this planet. And it wouldn’t be surprising if, in a few years, we would be liable to pay for that clean air and water. To keep track of all our expenses and more importantly, profits, help us learn of all the ways we can make further improvements to our finances. How to better save money, make more money and maintain our financial status.
Gross Profit vs Net Profit
For business owners, it is essential to monitor the profitability metrics. Two factors of these are gross profits and net profits. Both these terms are closely related and are significant for the company’s financial health. To learn about the performance of any company, investors need to consider these factors. The gross profit is the income that remains after only the costs of production have been deducted, while the net profit is the income that remains after all the costs and expenses have been deducted. There are other differences between the two terms.
Differences Between Gross Profit and Net Profit in a Tabular Form
| Parameters of Comparison | Gross Profit | Net Profit |
| Definition | Gross profit is the profit that remains after the costs of production and manufacturing have been deducted from the total earnings. | Net profit is the profit that remains after all the expenses, taxes and interest have been deducted from the total earnings. |
| Purpose | Gross profits help in reducing the costs of the firm. | The net profit helps to understand the proficiency of the firm better. |
| Functions | The gross profit helps to learn about the rough profits of the firm. | The net profit helps to find out the actual earnings gained by the firm in a financial period. |
| Reliability | Gross profits do not provide accurate data about the profits available, thus, do not effectively help in formulating business strategies. | Net profits are comparatively more dependable and help formulate business strategies. |
| Financial treatment | Gross profits find a place on the credit side of the Trading Accounts. | Net profits find a place on the credit side of the Profit and Loss Accounts. |
| Inclusions | Gross profits include overhead costs and taxes. | Net profits include the operating expenses, taxes and interests. |
| Formula | Gross Profit = Total Revenue – Cost of Goods Sold | Net Profit = Gross Profit – Expenses |
What is Gross Profit?
Gross profit can be defined as the difference between the total earnings or revenue and the cost of goods (COGS). The total revenue comprises the total earnings of the company during the financial period. The COGS is related to the production and manufacture of goods. It includes the following items:
- Direct labour (wages for labourers)
- Costs of direct raw materials (raw materials and inventory)
- Repair expenses
- Shipping charges
- Costs of equipment
- Production utilities
Gross Profits are noted under the Trading Accounts and give information regarding a company’s profit before all the expenses are deducted. It provides the investors with an idea of how effectively the resources and raw materials are being used and the production supplies. Thus, it helps to assess a company’s efficiency concerning the production and pricing activities.
However, gross profits do not offer any information about how the company would pay off the investors or reinvest in future ventures, which is why it is not as dependable as net profits when it comes to formulating a business strategy. Irrespective of that, gross profits are used to calculate the net profits of a company and hence are essential.
Gross Profit Calculation
To calculate the gross profits of a company, the total revenue must first be determined before deducting the expenses. The formula is as follows:
Gross Profit = Total Revenue – COGS
Let us see an example for the calculation.
A company – E Private Limited, has earned Rs. 10,00,000 in a financial year. Its cost of goods sold amounts to Rs. 5,00,000. Its gross profits are:
Gross Profit = Total Revenue – COGS
Gross Profit = 10,00,000 – 5,00,000 = 5,00,000
Thus, E Private Limited has a gross profit of Rs. 5,00,000.
Gross profits help monitor how the manufacturing and the labour costs affect the bottom line or the net profit before other costs like administrative costs come into the picture. A gross profit, thus, assesses how the company can sustain itself and make a profit while managing the costs of production and labour. It is important in determining a company’s rise or fall by taking the sales, production costs, labour costs and productivity into consideration.
For example, if company A hired minimal workers during its busy season, they would have to pay over-time charges for their labour. This would increase the labour costs. It would also destroy the gross profitability. Gross profits alone, therefore, cannot be used to assess a company’s financial efficiency. Other costs must also be considered.
What is Net Profit?
Net Profit can be defined as the profit that remains after the COGS, the operating expenses, the interests and the taxes have all been deducted from the company’s total revenue for that financial period. Therefore, net profits include additional income like interests on investments (short-term or long-term for additional income) and sale proceeds, wherein the operating expenses comprise the following:
- Salary
- Rent
- Depreciation (costs of fixed assets like equipment)
- Utilities
The net profit is a component of the Profit and Loss Accounts and is often referred to as the ‘bottom-line’ of the income statements. It is useful to the investors as it helps determine the profitability of the company. It is also used to figure out how a company can better convert sales into profits. This is the reason it is used to develop business strategies that could serve to maintain and improve the financial standing of the company along with its profitability.
Calculation of Net Profits
To calculate the Net Profit, one must know the Gross Profit of the company. The formula to calculate Net Profit is as follows:
Net Profit = Gross Profit – Expenses
Let us see an example for the calculation.
Say the company – E Private Limited earned a gross profit of Rs. 10,000 in its financial year. It has accumulated the following expenses:
- Rent = Rs. 500
- Utilities = Rs. 250
- Salary = Rs. 2000
- Depreciation costs = Rs. 500
- Office supplies = Rs. 200
- Interest = Rs. 250
- Taxes = Rs. 1000
The total expenses (summation of all the above mentioned expenses) = 500 + 250 + 2000 + 500 + 200 + 250 + 1000 = Rs. 4700
The formula for net profit is as follows,
Net Profit = Gross Profit – Expenses
Net Profit = 10,000 – 4,700 = 5,300
Therefore, the net profit of E Private Limited is Rs. 5,300.
Net profit is considered to be a more realistic representation of the company’s finances. Since it offers a clearer view of the financial health and potential cash flow, it is more attractive to investors. Solid gross profits will mean nothing if non-operational costs are reducing the company’s bottom line. Instead, positive net profits will send an accurate picture to the investors and raise the chances of attracting one.
Net profit, thus, represents profits gained from all aspects of a company’s operations. It is more inclusive than the gross profit and provides a more comprehensive view of the management team’s efficacy. For example, if a company has a good gross profit value but significant debt (a fixed asset that is calculated for net profit), the value of the net profit gained will be lower despite the company’s successful sales and productivity.
Main Differences Between Gross Profit and Net Profit in Points
Following are the main differences between gross profit and net profit:
- The gross profit is the profit that remains once the cost of production is subtracted from the total revenue, whereas the net profit is the profit that remains when all the expenses are subtracted from the total revenue.
- Gross profits serve to determine the rough profits of the company, while net profits help in finding out the actual earnings of the company.
- Gross profits help in reducing the costs of the company, while net profits help in evaluating a company’s proficiency.
- Gross profits do not provide accurate data about the profits of the company, which is why net profits are more reliable than gross profits to assess a company’s financial health.
- Net profits are better suited than gross profits when formulating a business strategy for a company.
- Gross profits are found on the credits side of the Trading Accounts, while net profits are found on the credit side of the Profit and Loss Accounts.
- Gross profits include overhead costs and taxes for calculation, whereas net profits include operating costs, taxes as well as interests for calculation.
- The formula for calculating the gross profit is as follows: Gross Profit = Total Revenue – Cost of Goods Sold; the formula for calculating the net profit is as follows: Net Profit = Gross Profit – Expenses.
Conclusion
Gross profit and net profit are hugely informative to business owners and investors. Gross profit is the profit that is gained after the production costs are subtracted from the total revenue. It helps provide a rough overview of the profits of the company. It also helps in assessing and minimizing the production costs of the company. Gross profits include only the overhead costs and taxes and can be calculated using the formula – Gross Profit = Total Revenue – COGS (Costs of Goods Sold). It is thus a summary of the sales and their impact on the productivity of the company.
Net profit, on the other hand, provides a more comprehensive view by taking into account all expenses. It offers a better view of the company’s cash flow and financial health. It is defined as the profit that remains once all the expenses are subtracted from the total revenue and are calculated using the formula – Net Profit = Gross Profit – Expenses. Since it is more comprehensive and includes additional costs like taxes and interest, it is a dependable parameter for assessing a company’s financial efficiency. It is also more attractive to the investors and is used to formulate business strategies. Both net profits and gross profits are critical to making educated decisions about a business. And keeping track of them helps thrive in the business. To excessively monitor these parameters is imperative much like monitoring one’s expenses. Not everyone after all is going to have a strong heart to bear the consequences of a shopping spree. That sinking feeling is going to stay for a while and while it does, tracking every financial decision, and keeping an account of every unnecessary expense can aid in tending the heart better. Someday, hopefully soon, practising this vigilance could lead to more sound financial decisions that cause you to not experience the sinking feeling the next time you flip your wallet to buy that coveted dress or the high heels that have been gracing your wishlist for ages. You deserve the little pleasures, after all, even if it is at an expense.
