As a small business owner, you might find yourself overwhelmed by financial formulas and having to work out your financial performance. However, grasping the concept of gross and net profit is crucial for making well-informed business decisions regarding pricing and expenses.
It might take a bit of time and trial and error to figure out your gross and net profits at first, but once you get the hang of it, you'll wonder how you ever managed without them!
- Gross profit: What you earn after subtracting what it costs to make or provide your product or service.
- Gross profit = selling price − cost of production
- Net profit: What's left after deducting all your remaining business costs, including salaries and rent.
- Net profit = gross profit − operating expenses
Defining gross profit and net profit
Gross and net profit may seem and sound similar, but they provide very different information that can be used for a number of different things.
What is gross profit?
Gross profit is the difference between the selling price of your product or service and the cost of producing it.
So, if you sell your candles for £11 and it costs you £3 to produce them, your gross profit is £8.
For a service-based business, it's the job price minus the cost of the time spent doing the job. It's crucial to understand gross profit to ensure you're not selling at a loss.
What is net profit?
Net profit is your gross profit minus all the other costs of running your business (commonly called operating expenses), including salaries, rent, software, and bank charges or credit card fees (if your business credit card charges these - Capital on Tap doesn’t charge monthly or annual fees).
These expenses are deducted from the gross profit to calculate net profit.
Make sure you don’t include the cost of producing your product again - this is already accounted for in the gross profit.
For instance, if your monthly operating expenses amount to £5 per candle, your net profit would be £3.
Because, gross profit (£8) - operating expenses (£5) = net profit (£3)
Understanding your net profit is crucial for assessing the overall financial viability of your business. This is because it reflects your business’ true profitability after considering all costs associated with both production and day-to-day operations.
So, a positive net profit indicates that your business is making money, while a negative net profit means your expenses exceed your earnings, basically you’re spending more than you’re earning, signalling potential financial challenges that may need attention.
What's the difference between gross profit and net profit
Gross profit: This is the money you make from selling your product after subtracting the direct costs of making or buying it. It's like looking at the earnings from your main business activity.
Net profit: It's the figure commonly referred to as profit. It takes a wider view; it considers not only the cost of making or buying the product (like in gross profit) but also all the other costs of running your business, such as rent, salaries, and utilities. Net profit gives you a more realistic picture of how much money your company is really making after considering all the expenses. It's like looking at the overall profit after everything is taken into account.
How to calculate gross and net profit
Finding out how much money your business is making can be simple if you keep your financial records organised. To calculate your gross and net profits, just gather info on all your business expenses, like:
- Money spent on raw materials (check your invoices)
- Utility bills (gas/electric/water etc.)
- Wear and tear on manufacturing equipment (depreciation)
- Packaging costs
- Expenses for machinery and tools
- Office supplies
- Marketing or advertising expenses
- Employee taxes and benefits
- Employee salaries
- Rent or mortgage for your business space
Both the net and gross profit calculations use these details, so it helps to have everything ready beforehand to make things easier.
If you have a recent profit and loss statement, it should show your total cost of goods sold.
If not, you can figure it out using this formula:
Cost of goods sold (COGS) = starting inventory + purchases – ending inventory
The starting inventory is the value of the inventory that was left over from the previous year. Purchases include the expenses associated with buying or making items throughout the year. The ending inventory is the value of the inventory at the close of the year.
Keep in mind that the cost of goods sold (COGS) is crucial because it's used in both gross and net profit calculations. Keep track of it, and use the formula regularly to stay informed about your company's profits, as the COGS may change over time.
How to calculate gross profit?
As mentioned earlier, this is the difference between the selling price of your product and the cost of producing it. In monetary terms, it's the income generated after deducting the direct costs associated with your product or service.
Gross profit = selling price − cost of production
Using an example, if you sell a sofa for £4,000 and it costs £1,200 to produce, the gross profit is £2,800.
Now that you've found your gross profit, you can move on to the net profit formula:
How to calculate net profit?
You need to use your gross profit calculation to understand your net profit.
Net profit = gross profit − operating expenses
As a reminder, your operating expenses are the day-to-day costs of running your business. This includes salaries, rent, software subscriptions, and any other costs necessary for the ongoing operation of your business.
Continuing the sofa example, say your operating costs per sofa are £800.
To calculate your net profit of selling a sofa:
£2,800 (gross profit) - £800 (operating expenses) = £2,000 (net profit).
Importance of gross and net profit
Gross profit helps you see how manufacturing and labour costs affect your finances before considering other expenses. It allows you to figure out how much money remains from your sales after covering things like raw materials and labour. This can help you spot issues like paying too much for materials or having too many workers. For instance, if most of your profit is going into raw materials, you might need to find a cheaper supplier.
On the flip side, net profit gives a broader view of your overall financial health. It includes all costs, not just production ones, giving insights into cash flow. Unlike gross profit, net profit is a key metric that can attract investors because it shows how profitable your company truly is.
Improving gross and net profit margins
Now you’ve calculated your gross and net profits, you can start looking at how to improve them.
How to improve gross profit?
- Cost reduction: Find ways to make your product more efficiently. Can you negotiate with suppliers for better material prices to lower costs?
- Pricing adjustments: Regularly check if your prices cover your production costs. If they don’t, you may need to increase your prices.
How to improve net profit?
- Expense management: Be smart about your spending. Can you reduce your utility bills by using energy efficient practices?
- Revenue optimisation: Look for ways to increase sales through marketing or new products.
The bottom line
Grasping the difference between gross profit (earnings after production costs) and net profit (earnings after all expenses) is essential for your business’ pricing, expense management, and overall financial health. Use gross profit to understand core earnings and net profit for a complete picture. Embrace these insights to make informed decisions, optimise costs, and ensure sustained profitability.
If you’re ready to enjoy enhanced cash flow, simplified expense tracking, the potential for rewards, and control over employee spending, apply for a Capital on Tap Business Credit Card in under 2 minutes today.
This does not constitute financial advice. If you want to understand your profits in detail, contact your financial advisor or accountant.