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A company generates two profits: net profit and gross profit. They help businesses prepare a more comprehensive financial statement.
Are you a business owner wondering about your profit gained? Do you want a lump-sum capital from investors?
Then, your company needs to have the finest financial status. To prepare, you must understand gross and net profit calculations. This will help measure profit against revenue. With the knowledge gained on the company’s performance, you can expand your business and make other financial decisions.
This blog will analyse the difference between net profit and gross profit. Further, we will explain calculations with the help of real-world applications.
Understanding Gross Profit
Gross profit is gained by a business when it sells products or services. The sales include all tangible assets, not fixed assets like tools and machinery.
The gross income is the value we get by subtracting the total revenue and the cost of goods sold.
Formula to Calculate the Gross Income of a Company
Gross Income/Profit = Total Revenue - Cost of Goods Sold (COGS)
Here, the total revenue indicates the company’s overall income.
The cost of goods sold represents the income earned by sales. It comprises the following charges:
1. The labour involved in production
2. Raw materials and packaging materials
3. Packing and shipping charges
4. Charges for tools operation
5. Processing fee
6. Sales commissions
The cost of goods sold excludes insurance, rent, property tax and marketing charges. Further, it is variable, i.e., it depends on the market demand and supply.
For instance, a juice company may get raw materials at a low cost for a certain period.
Importance of Gross Profit
While considering income tax efiling, with gross profit, you can better understand your business's capacity to convert revenue into profit. For example, your venture is efficient if you gain high gross profit with low COGS and make charges.
You can also find ways to choose low-cost materials and a cheaper workforce. Further, you can analyse your business’s product stance in the competitive marketplace and develop effective sales strategies. Thus, promoting or dropping a product lies with the gross income.
Example of Gross Profit
Let’s understand gross profit with an example.
To calculate the gross income for a chocolate manufacturing company in a financial year:
COGS for manufacturing is ₹42,000, which can be expanded as:
1. Cocoa: ₹20,000
2. Sugar: ₹10,000
3. Butter: ₹6,000
4. Packaging: ₹2,000
5. Running Equipment Charges: ₹4,000
Now, subtract the labour charge and processing fee of ₹10,000.
So, the total amount spent on COGS is ₹42,000 - 10,000 = ₹32,000.
Now, let’s assume the revenue generated is ₹62,000.
So, the gross income = revenue - COGS
= ₹62,000 - ₹32,000 = ₹32,000
Therefore, the total gross income is ₹32,000.
Understanding Net Profit
Net profit is the profit gained after tax and other deductions. It is the money that your company is left with after all bills have been paid. Net profit is the income mentioned in the income statement as the bottom line.
Net Profit Calculation Formula
Net Profit = Gross Income - Expenses
Your business expenses may include rent, income tax, marketing efforts, insurance, retirement contributions, and other utilities.
Importance of Net Profit
Net income helps analyse your business’s financial health effectively. You can find loopholes in spending and expenditure to plan a comprehensive budget. Moreover, it gives a clear picture of the investment needed for your venture.
Example of Net Profit
To calculate the net profit for the chocolate manufacturing company, consider the expenses of the unit.
Rent for Company Space: ₹1000
Insurance and Retirement Contributions: ₹5000
Marketing Expenses: ₹3000
Other Utilities: ₹2000
Total Expenses: ₹11,000
Now, incorporate the values in the net profit formula
Gross Income - Expenses = Net Profit
₹32,000 - ₹11,000 = ₹21,000
Hence, the net profit is ₹21,000.
An Income Statement Showing Net Profit and Gross Profit
After the calculation of the net and gross income, a company prepares an income statement as shown below:
ABC Company For the year ended 30 September, 2023 Total Revenue: ₹62,000 Cost of Revenue: ₹32,000 Gross Income: ₹32,000 Operating Cost: ₹4,000 Income Before Tax: ₹10,000 Income Tax Total: ₹2,000 Income After Tax: ₹8,000 Interest Expenses: ₹1,000 Net Profit: ₹9,000
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Gross Profit vs Net Profit: What Are The Differences?
The differences between net and gross profit are analysed below:
Aspect |
Gross Profit |
Net Profit |
Definition |
It is the amount obtained after deducting COGS from the total revenue.
|
The total amount a company takes home after deducting all expenses, including tax.
|
Insight |
It unveils the company’s efficiency in managing raw materials, labour, and manufacturing costs. |
It reveals the company’s financial situation after all expenses have been paid.
|
Calculation |
Gross profit can be calculated when the revenue and COGS are estimated. |
Net income can be analysed accurately only after the gross income calculation.
|
Purpose |
It gives insights into the company's total profit related to the products/services.
|
Net income provides the total profit the company has earned in a particular period.
|
Period of Calculation |
It is calculated for a certain accounting period. |
It is calculated for a certain accounting period. |
Reliability |
Gross profit is not reliable for planning a business strategy. |
Net profit is a revelation of total profit, making it reliable for building a business framework.
|
Income Statement |
Gross income is provided in the upper part of the income statement. |
The net profit is given in the bottom line of the income statement. |
Advantages |
Manufacturing expenses can be controlled.
|
Expenses depend on the taxing authorities.
|
Profit/loss Calculation |
Profit or loss of the company’s product can be decided. |
With net income, the overall profit or loss of the company can be calculated. |
Expenses
|
Gross profit expenses include tangible assets, manufacturing, and labour costs. |
Net profit includes operating costs, taxes, and interest. |
Formula
|
Gross Income = Total Revenue - Cost of Goods Sold |
Net Profit = Gross Income - Total Expenses |
Profitability Ratio: Gross Profit vs. Net Profit
The profitability ratio is the financial measurement of a company’s efficiency. The percentage calculated refers to generating a maximum profit using the availability of manufacturing units, labour costs, and other expenses.
The key parameters in assessing the profitability ratio include:
1. Financial statements
2. Revenue
3. Equity funds
4. Overall sales during the accounting period
It also acts as a comparison factor between similar industries. For example, two gold manufacturing companies selling the same product may have different profitability ratios. Usually, small businesses have a low ratio as compared to larger companies.
Investors look for this parameter when assessing the company’s viability. Furthermore, it encourages business owners to plan for higher profitability ratios in the future.
Gross Profit Margin Ratio
The gross profit margin ratio is commonly known as the gross margin ratio. It is the percentage of sales in a certain period.
In brief, the gross margin ratio is a company's money, deducting the cost of making charges in a percentage form.
The gross margin ratio formula is:
Gross Margin Ratio = (Gross Profit / Net Revenue) × 100
If a company produces a gross profit of ₹60,000 and a net revenue of ₹1,00,000, then:
₹60,000 / ₹1,00,000 × 100 = 60%
Net Profit Margin Ratio
The net profit margin ratio is also known as the net margin ratio. It indicates the overall profit of a venture’s profit in percentage.
Net profit margin is the metric that the stakeholders trust in a company. Consecutive good net profit margin attracts more cash flow.
You can calculate the net margin ratio by dividing the net profit (after subtracting the gross profit by expenses) by the total revenue multiplied by 100.
Net Margin Ratio = (Net Profit / Total Revenue) × 100
The net profit margin must always be lower than the gross margin ratio. This is because the expenses, taxes, and interests are not reflected in the gross profit margin.
A low net profit ratio means the company spends more on resources and workforce maintenance. Thus, the company’s management should analyse the budget and plan better financial strategies.
A high net profit ratio means the company has optimised the resources for high income. As a business, you can start expanding and investing more.
Conclusion
Understanding net and gross profit differences is essential for calculating a company's financial status.
Gross profit is a rough profit related to the products and services. The labour and manufacturing charges determine gross profit. Net profit refers to the overall profit the company generates. It is determined by other expenses your business makes.
Financial experts analyse these profits and prepare an income statement at the year's end. Thus, it attracts investors and stakeholders to invest in ventures for high returns.
