Gross Profit VS Net Income
In the pursuit of revenue, a business would have to incur costs.
If you’re in the business of selling goods, you’d need to purchases goods that you can sell.
If you’re in the manufacturing business, you’d have to purchase materials to convert into sellable goods, and you’d have also to pay for labor and any other costs involved in the manufacturing.
If you’re in the service industry, you’d have to pay for the cost of services.
Whatever it is that you earn from your business, there is a corresponding cost. And the amount excess of such costs, that is what you call your profit… gross profit to be exact.
When you deduct the cost of sales to your sales revenue, what you get is gross profit.
It shows you your earnings after considering the costs to produce revenue.
While revenue represents how much you are earning from your sales, gross profit represents how much you’re truly earning from your sales as it considers the costs of making such sales.
To compute gross profit, you just need to deduct costs of sales from the total revenue.
If there are sales discounts and allowances, deduct those from the total revenue too.
If we turn it into formula form, it should look like this:
Gross Profit = (Sales Revenue – Sales Discounts & Allowances) – Cost of Sales
Gross profit is a valuable tool for management as it shows whether a company is actually making a profit from its sales.
A company could be receiving payment from its sales, but if the costs of making such sales exceed the payment the company receives, is it truly earning?
For example, your company is selling a product for $10 each, but the cost for making the product amounts to $11, resulting in your company losing $1 for every piece of product sold.
In such a case, what do you think management should do?
They could either review their pricing, find ways to lower costs or do both.
While the standard for gross profit for each industry varies, it is universal that having a negative gross profit isn’t healthy for a company or business.
Management can compare the current year’s gross profit to previous years and see if it’s going with an upward or a downward trend.
Management can then make interpretations on what went wrong or what went right, and from there can design strategies to improve the company’s gross profit.
While gross profit is a good measurement of profitability, it only considers the earnings from operating activities, as well as the corresponding costs.
It does not consider earnings and spendings outside of operations, and the costs of maintaining the business (also known as operating expenses).
For that, we use another metric of profitability: Net Income.
When you look at a company’s income statement, you’d immediately notice that it doesn’t stop at gross profit.
That’s because there are other aspects to a business aside from sales and production.
Aspects such as the costs of maintaining the office of administrative staff, the rent expenses, the depreciation of the company’s assets… all these are expenses that a company can incur but cannot be fully pinned to sales.
A company can also earn and lose outside of its usual business operations.
Since these potential earnings and losses are outside of business operations, these cannot be captured by the gross profit.
For that, we use the Net Income.
Net income is what a company truly earns after considering all expenses.
It is the figure that goes to a company’s retained earnings at year-end.
It is the figure you’d arrived at after deducting from the total revenue the costs of sales, operating expenses, interest expenses, taxes, and dividends expense (if there are any).
If there are gains and losses generated outside of business operations (e.g. gain from the sale of fixed assets, dividend income from held stock, gains/loss from investment, etc.), they are considered too. If we turn it into formula form, it should be like this:
Net Income = Total Revenue – Cost of Sales – Operating Expenses + Gains (Loss) from other activities – Interest Expense – Taxes – Dividends Expense
Just like with gross profit, net income is a great tool to measure a company’s profitability.
A company with a positive net income will look more attractive than a company with a negative net income.
It shows management’s ability to manage costs and expenses while squeezing the most profit out of them.
Gross Profit VS Net Income – what are their differences?
Both gross profit and net income are line items in a company’s income statement.
Both are metrics of profitability. It is in their scope of measurement where they differ.
Gross profit only captures the profit made from business operations, while net income captures the profitability of the company as a whole.
As a result, net income is more comprehensive than gross profit.
In an income statement, gross profit is a line item that you will see at the top, while net income is a line item that you will see at the bottom (usually the last).
Both have their uses.
Gross profit is a great metric to use if management wants to know if a certain product is profitable, especially if the company is selling multiple products and is accounting for the sales and costs of each product.
For example, let’s say ZT company is selling three products: Brand X, Brand Y, and Brand Z. The sales data for the products can be seen from the table below:
Brand X and Brand Y had positive gross profits of $150,000 and $143,000 respectively, while Brand Z had a negative gross profit of $10,000 which meant ZT company lost money on Brand Z.
Now while the total gross profit of ZT company is a positive $283,000, it could have earned more if only Brand Z was more profitable.
From here, management can decide to either discontinue Brand Z to prevent more losses, or they can increase the sales price of Brand Z, or even find ways to reduce the cost of producing Brand Z.
Gross profit can also be used to compute the gross margin, a financial ratio that measures the profitability and efficiency of the company.
Gross margin can show how much the company is earning for every dollar of sale.
It is often compared to companies within the same industry to see if a company’s gross margin is competitive enough.
Net income, on the other hand, includes all aspects of the company, be it business operations or non-business operations.
It not only considers the cost of sales but also all the expenses connected with operating a business such as salaries expenses, utilities, and rent.
It also considers other income and losses from sources outside of business operations like gains or losses from investments.
This is why net income is a better metric to use when assessing the effectiveness of management.
Let’s take a look back at the ZT company example above. It has a total gross profit of $283,000.
Let’s say that it has total operating expenses of $150,000.
That would mean that their net income is $133,000.
Now, what if the operating cost were $300,000 instead?
That would mean that ZT would have a negative net income (or a loss) of $17,000.
Huh. So ZT was able to produce gross profit yet still have negative income?
A company can still produce gross profit, yet turn out negative when it comes to net income after all.
In such a case, there is no doubt that the fault lies within the management of operating costs.
It could be that current operating costs are disproportionate to the number of sales that the company is producing.
Management can then decided to reduce operating costs, or devise ways to bolster sales.
At the end of the day, net income is very important as it is the figure that returns to the company (as retained earnings).
A company that constantly produces negative net income might be a sign that that company is struggling with its finances.
Net income is the figure that most shareholders and potential investors look at rather than the gross profit.
It is the figure that concerns them after all. Dividends, the price of each share, the earnings of each share, all these things are related to net income and shareholders.
Limitations of Gross Profit and Net Income
While both gross profit and net income are good financial indicators, they both have their limits.
Gross profit only includes sales and costs from business operations, and so by nature, it is limited as to the amount of information it can give.
Net income on the other hand is very inclusive. So inclusive, that it may present misleading information.
For example, if a company gains greatly from a one-time transaction (such as the sale of a fixed asset), it will reflect in the company’s income statement and may greatly affect its net income.
It may cause investors to think that the company is very profitable, and may even think that it came from sales, and might finally invest because of it, when in fact, the gain from the one-time transaction had a big role in it.
This is why some companies have a separate line item in their income statement to show the income from sales after deducting costs and operating expenses.
It is usually termed operating income.
There are other measures of profitability aside from gross profit and net income such as the aforementioned operating income.
There is EBITDA which means “earnings before interest, taxes, depreciation, and amortization.
There is also EBIT which means “earnings before interest and taxes”, and EBT which means “earnings before taxes”.
All of these can be presented on the income statement.
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IRS.gov "Definition of Adjusted Gross Income" Page 1 . September 8, 2021
IRS.gov "Gross Income Defined" Page 1 . September 8, 2021
cornell.edu "Definition of net income and proceeds and standard for allocating net income or proceeds to various periods" Page 1. September 8, 2021