Most business owners understand profitability from a fundamental standpoint. If the revenue from sales covers your expenses, you’re turning a profit. Profits mean positive cash flow. Positive cash flow helps keep your business in operation. However, business owners should look beyond a simple profit naira amount. By calculating and comparing metrics, owners can identify the areas of the business that are working well, and those that need improvement. Get the full scoop on gross profit vs. net profit with this guide.
Gross Profit vs. Net profit
Before we get into the difference between gross profit and net profit, let’s first define what a profit margin is in more general terms.
What is profit margin?
Your business’s profit margin is a percentage value of how much your business earns for every naira made in sales. The more money your business earns for every sale made, the higher your profit margin becomes. Gross profit vs. net profit, on the other hand, are more specific (and different) measurements that are used to determine your business’s financial health. Let’s dig into the difference between gross profit and net profit.
What is gross profit?
Gross profit is how much money your business earns (revenue) minus only the cost of goods sold (COGS). But it should go without saying that there are many other expenses besides your COGS that your business must cover in order to keep running. So, gross profit is the measurement of profit before taking into account all expenses.
What is net profit?
Net profit is how much money your business earns minus all expenses, including taxes, operating expenses, loan repayments, COGS, and so on. Before you can calculate your business’s net profits, you’ll need to first measure your business’s gross profit. If you do the math and your ‘net profit’ is a negative value, it would correctly be referred to as ‘net loss’. Given these definitions, your business’s gross profit can be sky-high, but if you have lots of expenses to pay every month then your net profit could be much lower (or even negative).
Why knowing the difference between gross and net profit matters
When you own a small business, you need to know your business’s gross and net profits. Investors and lenders want to know about the financial health of your business, and showing them your gross profits just won’t cut it. You must know your company’s net profits when seeking outside lenders. That way, investors and lenders can determine how much money you have after paying all your expenses.
To create your income statement, you need to be able to calculate both gross and net profits. Confusing the two will only lead to muddled and inaccurate documents. You also need to know the difference between gross profit vs. net profit to make educated business decisions. Knowing your business’s gross profit can help you come up with ways to reduce your cost of goods sold or increase product prices. And if your net profit is significantly lower than your gross profit, you can determine expense cuts.
How knowing the difference between gross profit and net profit helps
Regardless of which industry your business is in, there are tons of useful and important insights that you’ll gain by learning the difference between gross and net profit.
- Use gross profit to help you develop the right pricing strategy for your business.
- Use net profit to determine how much you can set aside for a business disaster recovery plan.
- Use both gross and net profit measurements to help you beat the small business failure rate.
- Use both gross and net profit measurements to keep you prepared for the Tax Day deadline.
- Use net profit to see if you have enough money to scale up your business.
How to calculate gross vs. net profit
Now that you know what gross and net profits are, and the differences between the two, it’s time to learn the equations so you can calculate them. They’re very simple formulas, so there’s no need to be worried if you’re not the best with numbers.
Gross profit formula = Revenue – Cost of Goods sold
Net profit formula = Gross Profit – Expenses
Your break-even point is the point at which expenses and revenues are the same. You’re not making money at your break-even point, but you’re not losing money either. You should take time to measure your break-even point to determine how much “breathing room” you have in case things turn south.
As a business owner, you need to plan for the unexpected. Perhaps you lose access to raw materials because of a natural disaster, or one of your manufacturers suffers a warehouse fire and can no longer provide you with the goods you need. Whatever the case, knowing the break-even point will let you know how much you can afford to lose before you are no longer a profitable company. You can calculate the break-even point for various components of the business. For instance, you can measure the break-even point as a figure of sales. The formula to do so is:
Break-Even Point Sales = Fixed Expenses + Variable Expenses
You could also measure your break-even point against units sold. The method to do so is:
Break-Even Point for Units Sold = Fixed Expenses ÷ (Unit Sales Price – Unit Variable Expenses)
Running these figures allows you to determine how profitable you’ll remain in the future if something happens to your company.
The difference between gross and net profit is a crucial piece of knowledge to have in mind as you run your business. But even when considering the differences, the phrase ‘gross profit vs net profit’ is actually better understood in terms of cooperation as opposed to a challenge of some sort. You can’t measure your net profit without your gross profit, and your gross profit sheds only a small bit of light on your business’s true financial health.