Understanding the Difference Between Gross Profit and Net Profit

Profit is the economic benefits that flow into a business. The profit helps to assess the financial health of the business. Also, it helps to determine the growth of the business by comparing the profit of two consecutive accounting periods. However, to individuals and companies, there are two types of profit; gross profit and net profit. So, it is important to understand the difference between them. Both are calculated in the income statement.

What is gross profit?

This is the profit that a business earns after deducting the cost of goods sold (COGS) from revenue. The cost of goods sold is the cost directly relate to the goods sold or services rendered. So, it is a profit of a business before subtracting expenses. I.e. It does not consider other costs such as administrative cost, selling and distribution cost, finance cost, tax, and others. The formula for this profit goes thus:

Gross profit = Sales – the cost of goods sold (COGS)

Why gross profit?

It helps to measure the efficiency of a business in using its direct labor and supplies in the process of selling goods or services. So, it is important in measuring the profitability of the company. More so, it helps to determine the cost required to generate revenue. The cost of goods sold has an inverse relationship with gross profit if revenue remained constant. i.e. the decrease in the cost of goods sold leads to an increase in gross profit when revenue remained constant. It is important to know that gross profit is your actual profit. You can have a gross profit, but if the total amount of other expenses is more than gross profit, it will result in a net loss.

What is net profit?

This is a profit that a business earns after deducting all expenses from gross profit. To calculate net profit, you have to consider all the expenses over a period usually a year. So, it is a profit after deducting other expenses like selling and distribution, administrative cost, fiancé cost, tax from gross profit. Meanwhile, if the value of total expenses is more than gross profit, it results in a loss. The formula to calculate net profit goes thus:

Net profit = Gross profit – Expenses

Why net profit?

This measures the financial performance of a business. It is a yardstick to determine whether there is a need to control the current level of expenses or maintain it. Net profit is used to determine the success of the business organization. Additionally, it serves as a basis for determining the tax liability of a business. More so, it helps the lenders to decide on whether to provide a credit facility to the company or not.

Main differences between gross and net profit

  • Gross profit is the profit after deducting the cost of goods sold from sales. While net one considers all expenses.
  • Gross profit measures the profitability of the business, while net profit measures financial performance.
  • It is not wise to make a financial decision based on gross profit because it does not consider other costs. While users can use the net profit to make a financial decision.
  • While gross is calculated in the trading part of the income statement, net profit is shown in the profit or loss part of the income statement.

Calculation of gross profit and net profit

Both gross and net profit is calculated in the income statement. Let’s use this example, ADR Ltd has the following data for the year ended 31/12/2020:

                                                                                                   $

Sales                                                                                        10,000

Purchases                                                                                8,000

Opening inventory                                                                  2,000

Closing inventory                                                                    3,000

Sales return                                                                             1,000

Purchase return                                                                      1,500

Selling and distribution                                                           1,200 Administration                                                                        2,000

ADR Ltd.

Income statement for the year ended 31/12/2020

$$
Sales12,000
Sales return(1,000)
11,0000
Cost of Goods sold:
Opening Inventory2,000
Purchases8,000
10,000
Purchase Return(1,500)
Cost of goods available for sales8,500
Closing inventory(3,000)(5,500)
Gross profit5,500
Administration3,000
Selling and Distribution1,200(4,200)
Net Profit1,300

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4 thoughts on “Understanding the Difference Between Gross Profit and Net Profit

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