Net Profit & Gross Profit: The Key Differences
The word profit can take on several meanings. Understanding the difference is one of the many benefits of financial literacy training.
Your CEO could be talking about any number of things when referring to profit:
- Gross profit
- Net profit
- Quarterly profit
- Group profit
- Operating profit
They’re all different, and important, in their own way. However, the two most common variables of profit are gross profit and net profit.
Gross profit is Revenue minus Cost of Goods Sold. For example, imagine you own a company that buys widgets from China for £2 and sells them locally for £3. Your gross profit on each widget will therefore be £1. Assuming you sell 1,000 widgets during the year, your gross profit might look something like this:
Sales £3,000 – Cost of Goods Sold £2,000 = Gross profit £1,000
A healthy gross profit is important because it represents the viability of your business model. Obviously, you need to sell products for more than the price you bought them at. If your gross profit is too low, you’ll need to find a cheaper supplier, raise your prices, or find a new product altogether.
Obviously buying products isn’t the only expense on a business’s accounts. They also need to rent a store to display everything, hire someone to clean all the windows, take out insurance in case of a burglary or fire and hire a few good people to look after the store each day. These are known as operating expenses, and to calculate net profit, all of these need to be deducted as well. The income statement usually carries this information, and a simplified version might look like this:
Cost of Goods £2,000
GROSS PROFIT £1,000
NET PROFIT £400
As you can see, while gross profit is important, it is only half the challenge in creating a profitable business. A company must add a high enough mark-up to its products/services so that it can cover all expenditure. Only then is a net profit achieved, which represents a healthy, profitable operation.
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