When creating income statements and deciding how to manage your firm, it’s critical to understand the difference between gross profit and net income.
In this article, we are going to give you the detailed difference between gross profit and net income, the formula for net income, and gross profit with an example.
What Is Gross Profit?
After production costs are deducted from revenue, what is left over is referred to as gross income or gross profit. Gross income sheds light on the efficiency with which a business makes a profit from its sales and production operations.
What Is Net Income?
After all costs and expenses have been subtracted from total revenue, net income is an indication of how profitable an organisation is overall. Any additional income that a business receives, such as interest on investments or proceeds from the sale of an asset, is also included in net income.
Is Net Income or Gross Profit Higher?
Since gross profit has not taken into account various costs (such as taxes) and accounting charges (such as depreciation), gross income will nearly always be higher than net income.
Methods for Determining Gross Profit
Subtract the cost of goods sold (COGS) from the total sales income to determine the gross profit, as shown in the following equation:
Revenue – COGS = gross profit.
Revenue in the equation stands for the entire amount of money made from product sales, and COGS stands for the variable direct costs of manufacturing goods, which include expenses for labour, equipment, raw materials, and shipping.
Some companies may substitute net sales for total revenue when computing gross profit. Similar to total revenue, net sales also include discounts, allowances, and the cost of items that were returned or refunded.
Methods For Determining Net Income
To determine net income, start with gross income (the total amount of money earned) and remove costs like taxes and interest payments.
The net income formula is as follows:
Revenue – Cost of Goods Sold – Expenses = Net Income
The first element of the formula, revenue less cost of goods sold, is also the gross income formula. (For a simple explanation of how to calculate the cost of goods sold, see our guide).
In other words, the net income formula is:
Net Income = Gross Income – Expenses
If you want to keep things simple, you may write the net income formula as:
Net Income = Total Revenues – Total Expenses
Net profit can be either positive or negative. When your company’s revenues exceed its expenses, you have a positive net income. You have a negative net income, also known as a net loss, if your entire expenses exceed your total revenues.
Using the technique above, you can calculate your firm’s net income for any period: annual, quarterly, or monthly—whatever works best for your organisation.
What is the Difference Between Gross Profit and Net Income?
The difference between gross profit and net income is that gross profit does not take into account expenses other than the cost of goods sold. Business owners must understand both the company’s gross profit and net income.
The ability of a company to earn a profit while managing its production and labour costs is measured by gross profit. As a result, examining sales, production costs, labour costs, and productivity, is an important metric in determining why a company’s profits are increasing or decreasing. If a company reports an increase in revenue, but that increase is more than offset by an increase in production costs, such as labour, the gross profit for that period will be lower.
For example, if a company does not hire enough production workers for its busy season, it will have to pay more overtime to its current employees. As a result, labour costs would rise and gross profitability would decline. However, using gross profit as an overall profitability metric would be insufficient because it does not account for all of the other costs associated with running the business.
Net income, on the other hand, represents the profit from all aspects of a company’s business operations. As a result, net income is more inclusive than gross profit and can provide insight into the effectiveness of the management team.
A company, for example, may increase its gross profit while borrowing excessively. Despite the company’s successful sales and production efforts, the additional interest expense for servicing more debt could reduce net income.
An Example of Calculating Net Income and Gross Profit
You can use the following example to see how gross profit and net income are calculated and how they relate to one another:
Bicycles and accessories are designed, produced, and sold by Enjoy the Road, Incorporated. The revenue of this business may be made up of £286,956 from the selling of bicycles, £16,397 from the sale of accessories, and £10,658 from the sale of tickets for an annual cycling competition the business sponsors.
You may estimate the company’s revenue in this case as £286,956 + £16,397 + £10,658, which is £314,011 in revenue.
The following costs may be incurred by the same business:
- Cost of payroll: £57,391
- Rent for a warehouse: £4,099
- Maintenance of equipment: £1,230
- Electricity: £984
- Materials: £40,995
- £49,192 in labour costs for production
According to these numbers, the company’s overall expenses would be £153,890. Given that you are aware of the entire sales and total outlays for the company, you can use the formula £314,011 – £153,890 to arrive at a net income of £160,121. This indicates that the business is making a net profit of £160,121.
You might utilise the costs that are included in the cost of goods sold, in this case, the supplies and labour for production, and deduct them from the total revenue to determine the company’s gross profit. This is how the computation might appear: Total revenue of £314,011 minus cost of goods sold of £90,186 equals £223,826 in total.
Why Is Net Income Important to Businesses and Investors?
Net income is important to businesses and investors for several reasons. The following are the reason.
- Net income is a measure of profitability. It shows whether a business is making money or losing money.
- Also, Net income is used to calculate key financial ratios, such as profit margin and return on equity. These ratios are important for investors and lenders.
- Net income is used to determine how much tax a business owes. This is important for both businesses and the government.
- Net income is used to calculate earnings per share (EPS). This is an important metric for investors, as it shows how much profit each share of stock is earning.
- Also, Net income is used to determine dividends. This is important for investors who receive dividends from the companies they invest in.
- Net income is used to make financial projections. This helps businesses and investors to plan for the future.
The Importance Of Gross Profit To Businesses
Gross profit is an important metric for determining a company’s operational efficiency and profitability. It demonstrates how well a corporation uses its resources, like labour and supplies, in the manufacturing process.
A higher gross profit indicates that the corporation generates more revenue per dollar of COGS, implying effective cost control and potentially healthier profit margins. Gross profit also gives business managers useful information about pricing strategies.
If the gross profit is too low, it may imply that the prices of goods or services should be raised or that the COGS should be reduced, either by cost-cutting initiatives or more efficient manufacturing practices.
Users of Gross Profit Vs Net Income
The primary difference between gross profit and net income, in many cases, is the different user bases and their intentions with the information.
#1. Business Owners and Executives
Gross profit information is used by business owners and managers to assess the profitability of their core business operations. Although net income is used by business owners, select department heads will be more interested in how actual product manufacturing and sales perform without accounting for administrative costs.
#2. Investors
Net income is a key metric used by investors to evaluate a company’s profitability and growth potential. Investors may be turned off if a company does not have a positive net income. Even if a company has a positive gross profit, investors are more interested in net income and potential future dividend distributions (from net income, not gross profit).
#3. Banks and Lenders
Net income information is used by lenders and financial institutions to assess a company’s creditworthiness and make lending decisions. As a result, before issuing credit, banks frequently require a company to provide an income statement (and often a multi-year income statement). Though the bank may underwrite based on the gross profit of primary product lines, net cash flow after all expenses is what banks are most interested in (especially interest).
#4. Tax Collectors
Gross profit is not taxed by governments. Federal, state, and local taxes are frequently assessed after all expenses have been taken into account. Though some tax credits and deductions are closely related to gross profit, government entities are more interested in a company’s net income when assessing tax.
Limitations of Net Income and Gross Profit
On its own, gross profit is not a very helpful metric. Net income is much more useful in assessing a company’s financial situation. However, even net income has its limitations because it can only be used to compare the performance of one firm from year to year.
Even if two companies are in the same industry, comparing their net incomes won’t provide much insight.
According to how that business records its expenses, it simply informs you which one earned more income. Non-cash expenses are not taken into account when calculating net income, which might be deceptive. Net revenue may be significantly decreased when these are deducted.
Is Net Income An Asset or Liabilities?
Logic follows that if assets must equal liabilities plus equity, then the change in assets minus the change in liabilities is equal to net income. That’s assuming, of course, that there were no capital transactions in the equity account — dividends to owners, or new investments by the owners.
Is Net Income Also Equity?
Net income contributes to a company’s assets and can therefore affect the book value, or owner’s equity. When a company generates a profit and retains a portion of that profit after subtracting all of its costs, the owner’s equity generally rises.
The Difference Between Profit and Income is What?
The primary difference between profit and income is that profit refers to the amount realised by the business after deducting expenses from the total amount of revenue earned during an accounting period, whereas income refers to the amount that remains in the organisation’s earnings after deducting other expenses.
What Makes Gross and Net Easier to Recall?
Gross pay, or the higher number, is the “great” or “grand” pay. The analogy between a fishing net and net pay is the most effective approach to recalling the difference between gross profit and net income.
Why is Using Net Income Rather Than Gross Income Important?
Your net income can help you develop a more accurate sense of how much money you have available to spend, and it also serves as a good predictor of your annual tax burden.
Conclusion
Gross profit, also known as gross income, is an important profitability metric because it shows how much profit is left over after deducting production costs from revenue. Gross profit demonstrates how effective a company is at generating profit from the production of its goods and services.
Net income, on the other hand, is the income or profit that remains after all expenses are deducted from revenue. Although net income is widely regarded as the gold standard for profitability, some investors prefer other metrics, such as earnings before interest and taxes (EBIT). EBIT is significant because it reflects a company’s profitability without the cost of debt or taxes, both of which are normally included in net income.
Related Articles
- Salesforce CRM Review: Pros, Cons and All You Need to Know
- What is EBIT (Earnings Before Income and Taxes)?
- Net Revenue: Definition Formula and All You Need To Know
- Cost of Sales: Definition, Formula, and Examples
- Revenue vs. Turnover: Key Differences 2023
Reference
