What is net profit and how is this calculated?

Revolut Contributor

· 06/05/2020  · 06/05/2020

Net profit is a firm's total revenue over a given period once the costs of providing its goods or services are deducted. In the UK, the notable exceptions are the tax due or interest owed on bank loans. Put simply, what we are calculating is the turnover (i.e. revenue) of the business minus its allowable running costs but before tax or interest owed to the bank are taken off.

This is such a vital metric of how well a business performs that it is also commonly referred to as bottom-line profit. Get this one wrong, and you might be in a sticky situation.

What is the difference between gross and net profit?

Gross profit is the value of a firm's revenue, minus the day-to-day running costs of the business that relate directly to achieving these sales. The figure excludes more general overheads such as the rent paid for an office or the wages of the administrative team.

Gross profit = Revenue – Direct costs

We cover gross profit in far more detail here and explain what insights each of these two different types of profit reveal here.

How do you calculate net profit?

There are two main ways to do this. You either start with revenue and subtract all relevant costs or take the figure for gross profit and then deduct only the indirect costs.

Net profit = Gross profit – Indirect costs

This net profit definition sometimes uses different terms, which might cause confusion. For instance, revenue is often called turnover or total sales, but this is merely the full value of whatever the business sold. Indirect costs, also known as overheads, includes rent on a premises or wages of non-sales teams. Direct costs, such as raw materials for its products, are already deducted to calculate the gross profit which is why this method is easier.

Let's look at the following example. Avocado Ltd is a fictional firm that makes and sells fruit-shaped furniture in London. Over the past year, it achieved £100k in sales with a gross profit of £50k. The company also spent £10k on machinery, £10k on factory rent and £5k on admin staff .

Net Profit = Gross profit (£50k) – Indirect Costs (£10k + £10k+ £15k) = £25k

How do you calculate the net profit margin as a percentage?

Net profit is typically shown as a currency value for a specific period and indicates how profitable a business is during that time. That said, a more useful tool is the net profit margin formula, as this reveals how much net profit the firm makes for each pound it generates.

The method to work this out is below and the answer is generally shown as a percentage, which is what we've done here.

Net Profit Margin (%)= (Net Profit / Revenue) / 100

Let’s apply this approach to our earlier example for Avocado Ltd:

Net Profit Margin (%) = (£25k / £100k) 100 = 25%

We now see that for every £100 it receives in sales, Avocado makes £25 in net profit. This figure provides a clearer picture of the firm's performance.