Gross Profit vs. Net Profit Explained Simply

Gross profit is the amount of money a business retains after subtracting the cost of goods sold (COGS) from its total revenue.

It represents the efficiency with which a business produces and sells its goods or services.

Net profit is slightly different. Net profit is the remaining income after all expenses — including COGS, operating expenses, taxes, interest, and other costs — have been subtracted from the total revenue.

The critical difference lies in the scope of expenses considered.

Gross profit only accounts for production costs. Net profit encompasses all business expenses, providing a more complete picture of a business’s financial standing and overall profitability.

Let’s take a closer examination and flesh out the difference with examples.

Gross profit is one of the key financial metrics to track. It shows the profit a company makes after deducting the direct costs associated with producing its products or services.

Here’s the gross profit formula:
Gross Profit = Revenue−Cost of Goods Sold (COGS)

Let’s put some numbers in here to show what we mean. Let’s say a furniture company sells $500,000 worth of tables in a year. But it took money to make the tables. Raw materials and labour costs amounted to $300,000.

Gross Profit = $500,000−$300,000 = $200,000

There are limitations to what gross profit tells us. It doesn’t account for other operating expenses:

• Rent
• Utilities
• Admin costs
• Other expenses

As such, we use gross profit to measure how well a business uses its available resources to produce and sell products. Yet, we don’t use gross profit to measure profitability.

Gross profit is crucial for several reasons:

• Operational efficiency is a key factor that will determine a company’s long-term health and prospects.
• Understanding gross profit helps to inform pricing strategies, letting you know to set prices that cover production costs.
• A healthy gross profit margin can make a company more appealing to investors. Efficient operations (as proven by impressive gross profit) are one aspect that prospective investors will keep an eye on.
• Analysing your gross profit calculations can identify opportunities to optimise production costs. If one area seems disproportionately high (certain building materials, for example), you can target it to find cost-saving strategies.

Net profit is more comprehensive — it’s the actual profit after deducting all expenses and costs from total revenue.

Expenses here can include COGS, operating expenses, loan interest, taxes, and any other costs.

Here’s the net profit formula:
Net Profit = Revenue − Total Expenses

Example:

Using the previous furniture company

• Revenue: $500,000
• COGS: $300,000
• Operating expenses: $150,000
• Interest and taxes: $30,000

Here’s the net profit calculation:
Net Profit = $500,000−($300,000+$150,000+$30,000) = $20,000

Net profit is essential because it:

• Measures overall profitability. Net profit reflects the company’s ability to generate profit from all expenses.
• Guides dividend payouts and reinvestment. Net profit informs decision-making on distributing profits to shareholders or reinvesting in the business.
• Indicates creditworthiness. Lenders will assess net profit as a key determiner of a company’s ability to repay loans.
• Aids strategic planning. Net profit provides insights that will affect long-term business strategy, helping to find growth opportunities. For example, if a business sees a consistent increase in net profit over several quarters, it might choose to invest in new product development or enter new markets.

However, net profit also has limitations. It doesn’t highlight specific areas like production efficiency or the costs of goods sold, which would require separate analysis.

Understanding the difference between gross profit and net profit is vital for a comprehensive evaluation of a company’s financial health.

You can calculate both gross and net profit using an income statement. An income statement shows your company’s total revenue and cost of goods sold to calculate gross profit. You follow this with the operating expenses, interest and taxes to calculate net profit.

It’s worth noting you must calculate gross profit as a prerequisite for calculating net profit. Let’s give another hypothetical example - an income statement for the tech company Tech Solutions Ltd.

This example income statement is a clean hypothetical. In reality, the figures wouldn’t be so simple, and there may be a longer list of expenses to consider. Yet, you can see the example illustrates a few things:

• Tech Solutions has a substantial gross profit of $600,000. This indicates an efficient business that is using its resources well to generate revenue.
• Once you account for ALL expenses, the net profit comes down to $250,000. This shows the business is profitable.
• The business owners can pay themselves and their partners after paying off their expenses since they have avoided a net loss.
• The business owners can now decide what to do with any remaining net profit as part of their longer-term strategy.

Both metrics are important in their own right. What you want to be paying attention to will depend on what question you’re looking to answer. Your industry may also affect which metric you want to pay more attention to.

For example, if you are in the manufacturing and retail industries, calculating gross profit is absolutely pivotal to analyse. You need to comprehensively understand production costs and the resulting pricing strategies since these are the bread and butter of your business.

Your business lives and dies by its operational efficiency, which gross profit will indicate.

On the other hand, service-based businesses or SaaS companies have fewer direct production costs. Operational expenses play a more significant role for these businesses. As such, gross profit is less important.

The fundamentals are true regardless, though. Net profit is the figure which gives you a better idea of your overall profitability.

Net profit is the key metric that lenders and investors will look toward. That’s because it indicates the company’s profitability — the ability to generate returns and repay debts. In other words, net profit is the better indicator for assessing financial health and, crucially, sustainability over a longer period of time.

The crucial takeaway here is that no matter what your circumstances, you should pay attention to both gross profit and net profit to get an accurate picture of your finances.

The financial metrics don’t stop at gross and net profit. Any accountant worth their salt will look at various other financial indicators that provide specialist insights into a company’s performance.

Let’s spotlight a few:

Operating profit, or Earnings Before Interest and Taxes (EBIT), measures the profit from your core business operations excluding interest and taxes:

Operating Profit = Gross Profit−Operating Expenses

Using our Tech Solutions income statement, here’s the operating profit:

Operating Profit = $600,000−$300,000 = $300,000

EBIT is useful for finance professionals who want to zero in on core performance. By excluding interest and taxes, you get a clear view of how well the company performs in its primary activities.

If you are interested in comparing companies, looking at EBIT allows for more accurate comparisons regardless of their capital structures or tax environments, which can change due to external factors.

Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) evaluates a company's operational performance by excluding non-operational expenses (interest and taxes) and non-cash expenses (depreciation and amortisation).

Amortisation is the name given to the act of paying off the initial cost of assets.

As such, EBITDA takes operating profit a step further. EBITDA provides an idea of the company’s cash flow.

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation

Assuming Tech Solutions Ltd. has:

• Net Profit: $250,000
• Interest Expenses: $20,000
• Taxes: $30,000
• Depreciation and Amortisation: $50,000

Using that example, here’s how to calculate EBITDA:

EBITDA = $250,000+$20,000+$30,000+$50,000 = $350,000

EBITDA helps you understand the company's operational performance without the impact of financing decisions, tax environments, or non-cash expenses.

It's particularly useful for comparing companies in industries that require significant investments in assets, like manufacturing or telecommunications, because it focuses on operational profitability.

Return on Assets measures how effectively a company uses its assets to generate profit. In other words, it shows how good the company is at converting its investments into net income.

How to calculate ROA:

ROA = (Net Profit​ / Total Assets) ×100%

If Tech Solutions Ltd. has total assets worth $2,000,000:

ROA = ($250,000 / $2,000,000​) ×100% = 12.5%

ROA tells you how efficiently a company is using its assets to generate profits. A higher ROA is a good sign of more efficient use. Again, this is especially relevant to businesses with a significant outlay on equipment, like those in manufacturing.

Cash flow from operations shows how much cash a company generates from regular business activities. Unlike net profit, which can include non-cash items, this metric focuses on the actual cash inflows and outflows within any given period.

This metric matters for day-to-day operations. Even if a company is profitable on paper, it might struggle if there isn’t enough cash on hand to pay the bills. Monitoring cash flow from operations helps ensure the company always remains solvent on a month-to-month basis and can fund its many activities.

Using these additional metrics (and there are others, too) provides a more complete picture of financial health.

On a very simple level, let’s revert back to Tech Solutions. Imagine you’re considering investing. Looking at net profit alone might not tell you everything you need to know.

By also examining operating profit and EBITDA, you can see how well the company's core business is performing and how much cash it's generating from its operations. You believe there are going to be tax changes in the future that will be beneficial to the company, or you know that the company is close to writing off some of its initial startup loans.

This more nuanced yet still oversimplified analysis makes Tech Solutions a more attractive investment.

As a general rule, looking at a company's financial performance beyond just gross and net profit will help you make better business decisions. This holds true whether you’re an investor, a manager, or any other stakeholder in the business.

Gross profit and net profit are two key fundamentals for assessing different aspects of a company’s financial performance.

• Gross profit sheds light on production efficiency and cost management.
• Net profit better reveals overall profitability after all expenses.

Consider both metrics to make informed business decisions for growth. But, in truth, these two metrics alone won’t be enough. Broaden your perspective by using other metrics, such as EBIT, EBITDA, ROA, net profit, and gross profit margins.

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