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Gross Profit and Net Profit: An Explainer

Gross Profit and Net Profit: An Explainer

We all know that a business needs to make a profit in order to be successful. But what is the difference between gross and net profit? Find out more here.

14th January 2020
Reading Time: 3 minutes

Profits, margins, markups, and turnovers. There are many terms used in the business world to help us monitor its health, success and issues. Gross profit and net profit are 2 such features and incredibly important to be aware of. Whether you have an existing business, or about to start one, this article will shed some light on each of these terms, and how to calculate them for your business.

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Gross profit margin ratio

Gross profit margin is what is known as a profit ratio. This means it will show you the proportion of profit you are keeping from every sale you make, before expenses. In most industries, the higher the margin, the better.

(Total business income – cost of sales) divided by total business income.

Net profit margin ratio

Net profit margin is another profit ratio used in business. Unlike the gross margin, this calculates the proportion of profit you keep from every sale after expenses. Similarly, for most industries the higher the margin the better as well.

(Total business income – total expenses) divided by total business income.

Gross profit vs net profit

You can see here how both of these ratios are essential to your business and financial calculations. Gross profit is a simple calculation of goods sold minus costs of making those goods. Net profit on the other hand is better indication of actual profits, because it factors in operating expenses as well.

It may be tempting to think you only need net profit. After all, it takes into account sales and costs as a whole while gross profit does not. However, don’t forget the importance of the gross profit as well.

Knowing your gross profit is important to see how efficient management is at sourcing products and selling them at an effective rate. It measures the production process and can narrow down any issues in that department. This is why is so important to keep net and gross profits separate.

Net profits is able to demonstrate if the operating costs are too high. This includes factory rent, employees, administration costs and the like. If your gross profits are very good, but net profit is an issue, you can see straight away that you need to do something about the costs of your operation, as opposed to your production line.

For investors, net profit is more important for them to see how efficient their business is running. When trying to gain investments, selling a business or franchising it, this financial information is important to calculate properly. Drafting it up correctly on your business plan is also very important to protect yourself legally. Consult a business lawyer for more in depth and relevant assistance to your business.

Conclusion

At the end of the day, both gross profit and net profit ratios are used and critical to your business. It assess your business health, shows you how successful your business is and where they are any issues. These calculations can also be done without accurate numbers. If you are able to roughly complete those algorithms, you can do a draft calculation. This can allow you to identify problems before they arise, so you can be proactive and prevent costly dramas happening at all.

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Author
Taeisha Dou

Taeisha is a Legal intern at Lawpath. She is a Law student at Macquarie University, previously completing her Commerce degree. She has an interest in Commercial Law.