Gross profit vs net profit is the eternal battle of two rival metrics. Each is a vital indicator of how a company performs– and they are linked, as one is typically used to calculate the other.
To calculate gross profit, take a firm's revenue and subtract the day-to-day running costs that relate directly to these. Exclude overheads or fixed business expenses such as rent.
Gross profit = Revenue – Direct costs
Revenue is sometimes called turnover or total sales, and is basically the full value of whatever the business has sold. Direct costs are commonly known as the ‘cost of goods sold’ or COGS, especially if a firm makes or sells products. We cover gross profit in detail here.
Net profit is the gross profit, less indirect costs, and is simply the turnover of the business minus all its allowable running costs before tax or interest owed to the bank is taken off. Indirect costs are the overheads that don't contribute directly to sales. We cover net profit in detail here.
Net profit = Gross profit – Indirect costs
Gross profit vs net profit: which is the more useful figure?
Gross profit provides a handy snapshot of business performance and is the cornerstone of all profit calculations. Because of its focus on costs that directly relate to sales, gross profit is a good indicator of how profitable a specific product-line is, which can help to identify potential efficiencies. Its limitation is that, by definition, gross profit excludes a wide array of costs and so reveals far less about the underlying financial health of the business compared to other profit metrics.
Net profit provides a far more accurate overall reflection of how the business is doing and so is often known as bottom-line profit. This is the figure used to calculate the amount of tax due, and also enables it to create meaningful forecasts or make investment decisions.
Net profit is also one of the first numbers that any investor or bank will ask for during a conversation about raising finance or securing credit. You need to know this.
How do you calculate the margin for gross or net profit as a percentage?
The gross or net profit has a monetary value for a specific accounting period, and either figure can be negative if the company made a loss during that time. To convert each one into its respective profit-margin as a percentage, you divide it by the revenue:
Gross Profit Margin (%)= (Gross Profit / Revenue) / 100
Net Profit Margin (%)= (Net Profit / Revenue) / 100
Here is where things get interesting because each of these two ratios reveals how much profit the firm makes (i.e. gross or net) for every pound of revenue it generates in sales.
Are there other profit metrics you should know about?
It's easy to say gross profit is a less incisive tool than net profit, and there is some truth in this. Even so, there are situations where the opposite is true. For instance, a hefty one-off cost to a firm, such as machinery or a patent, can transform net profit into a blunt instrument.
This is why more nuanced indicators of profit, such as operating profit or EBIT, are popular. The secret is not to be seduced by one specific type of profit metric in isolation. Instead, adopt a broader view of a company's financial statements to gain perspective.Sign up in minutes
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