Gross Profit vs. Net Profit: What's the Difference and Why It Matters

Reaching your sales goals feels like a win — until you realize that not all of it turns into profit. Many businesses celebrate when they see revenue numbers rise, only to watch expenses eat them up, leaving little to show for their efforts. That’s where understanding gross profit vs. net profit is essential. The metrics are closely related, but they mean different things: One shows what’s left after direct production costs while the other shows real, sustainable profit.

Gross profit and net profit are both indicators of financial standing. Their main difference is the types of expenses that are factored into the formulas.

• Gross profit: Amount of money a business retains after subtracting the cost of goods sold (COGS) from its total revenue
• Net profit: Remaining income after all its expenses — not just COGS — have been subtracted from its total revenue

This means that they're used differently, too. Because gross profit only considers production costs, it only provides information about how efficiently a business sells and produces its goods and services. Net profit is different. Because net profit considers all business expenses, it provides a more comprehensive view of your business's overall financial standing.

The differences are nuanced, so let's dive a bit deeper.

Gross profit shows the amount of income a company makes after deducting the direct costs associated with producing its products or services. Effectively, this is the profit you earn before taking overhead costs into account.

The gross profit calculation relies on only two numbers: revenue (which is income that's generated by selling your products or services) and COGS (which are the direct costs a business incurs to produce a product or service). Here is the gross profit formula:

Gross Profit = Revenue − Cost of Goods Sold (COGS)

Let's say a furniture company sells $500,000 worth of tables in a year. It costs them $300,000 in raw materials and labor to make the tables. Their gross profit would be $200,000.

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

Gross profit shows how much income a business reports after paying for all the direct costs of production and selling. This means that gross profit can be used to:

• Measure operational efficiency: Gross profit can determine if a business is using its resources (time, money, labor, materials, etc.) appropriately to deliver its products or services.
• Guide pricing strategy: Understanding gross profit helps inform pricing strategies, enabling you to set prices that cover production costs.
• Assess sales performance: Because one of the numbers in the gross profit calculation is revenue, gross profit can provide some information about sales performance. If you look at gross profits while using sales analytics software, you can gain valuable performance insights to boost your sales numbers.
• Entice investors: A healthy gross profit margin indicates more efficient operations, making a company more appealing to investors.
• Uncover cost-saving opportunities: While analyzing your gross profit calculations, you might find opportunities to optimize production costs. If one line item seems unusually high, you can look for ways to reduce those costs. For example, if a particular material cost is higher than you want it to be, you can try to find a less expensive material to use in its place, change suppliers, ask for bulk-order discounts, or even reformulate your product to use less of those types of materials.

Gross profit tells just one part of the story. Contrary to what the term is called — gross profit — it doesn't tell you whether a business actually turns a profit.

Gross profit only accounts for COGS. It doesn't account for other operating expenses, like rent, utilities, interest, taxes, and other administrative or overhead costs. If a business has exorbitant overhead costs, it may not be profitable even if it's reporting a positive gross profit number. This is why it's important to consider both metrics to determine if a business is financially healthy.

Net profit is the amount of money a company makes after deducting all business costs. It considers COGS but also includes expenses like:

• Overhead costs (utilities, office supplies, rent, marketing, advertising, professional services, salaries of administrative staff, etc.)
• Interest
• Taxes
• Non-cash expenses (depreciation, amortization, inventory write-downs, etc.)

Unlike gross profit, which only considers direct costs of selling a good or service, net profit includes all expenses that are necessary to run a business. Here's the net profit formula:

Net Profit = Revenue − Total Expenses

Let's look at the same furniture company we discussed previously:

• Revenue: $500,000
• COGS: $300,000
• Operating expenses: $150,000
• Interest and taxes: $30,000
• Depreciation: $2,000

Here's the net profit calculation:

Net Profit = $500,000 − ($300,000 + $150,000 + $30,000 + $2,000) = $18,000

Net profit shows the true financial health of a business after all expenses are paid or incurred. This means that net profit can be used to:

• Make informed decisions: Knowing how much income remains at the end of the period gives leaders a clear picture of what resources are available for them to use in future periods. Depending on their goals, they might choose to invest those funds, grow the business, set aside reserves, pay off debt, or distribute dividends.
• Indicate creditworthiness: Lenders will use a company's net profit — not its gross profit — to help determine its ability to repay loans, and that's because net profit reflects the resources a business has to meet new and existing financial obligations.
• Aid in strategic planning: Tracking net profit over months or years reveals certain trends, which can inform long-term business strategy. 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. If there's an especially high profit year, they may choose to pay out bonuses to employees or purchase a piece of equipment.
• Measure overall profitability: Net profit is the bottom line. It reflects whether a company's revenues can cover the direct costs of production, but also overhead, taxes, and interest, which makes it the most complete measure of long-term business sustainability.

Net profit is a useful number, but it has some limitations. Net profit lumps all expenses together, which doesn't help you determine if the cost of production is appropriate or reasonable. Not only that, but net profit doesn't always equal cash on hand. For some companies, net profit often closely resembles how much cash is on hand, but it doesn't always. Net profit also considers non-cash expenses and adjustments like depreciation and amortization. Businesses looking to understand their cash position will need to look at cash flow forecasts instead of net profit.

To help summarize everything we've learned about gross and net profit, let's review the major points. These are the six main differences between gross and net profit:

• What expenses each one considers
• What each metric tells us
• Their scope of use in decision-making
• Their common uses
• Their calculation
• Where they appear in the financial statements

Refer to the table below if you need to be reminded about how these metrics are different.

You can calculate both gross and net profit from an income statement. Most income statements list both figures.

An income statement shows your company's total revenue and cost of goods sold, which you use to calculate gross profit. (Recall that gross profit is total revenue minus cost of goods sold.) You follow this by subtracting operating expenses, non-operating expenses (such as interest), and taxes to find net profit.

Calculating gross profit is a necessary step before determining net profit. Let's review a hypothetical example: an income statement for a fictional tech company.

In real life, the numbers on an income statement won't be as clean, and a much longer list of expenses would need to be considered. But this example illustrates a few things:

• The business is using its resources well: Compared to its $1 million revenue, the company's $600,000 of gross profit is impressive, reflecting a 60% gross profit margin. This shows the business is using its resources efficiently and has a solid pricing strategy.
• The business's expenses are reasonable: After deducting all other expenses, the net profit is $250,000, indicating a 25% net profit margin. This demonstrates that the business effectively manages its operating expenses and overhead costs.
• The business has strategic flexibility: A positive net profit provides flexibility to the owners. Depending on the business structure and their long-term goals, they might choose to take distributions, invest in business expansion, or keep funds for future opportunities.

Both metrics are important because they can help you make better business decisions, and investors and lenders want to see them. The metric that you or a third party uses depends on what question is being asked.

Lenders and investors usually focus on net profit because it shows a company's true profitability — its ability to generate returns and pay off debts. Because net profit captures every expense, it's a more reliable indicator of whether the business is sustainable in the long run.

That said, gross profit still matters.

Gross profit isn't a true indicator of a business's overall profitability. Rather, it's an indicator of the profitability of the sales and production process. And lenders want to see this. If a business shows that it makes its sales and delivers its product or service efficiently, it gives the business a lot more flexibility to manage its overhead costs. Consider startups for a moment. Often, startups have high overhead costs as they get their businesses up and running. Lenders may still want to invest in a startup if that startup is showing efficiencies in the sales and production process.

Some industries also consider gross profit a key metric for decision-making. For example, businesses in manufacturing and retail often face high production costs. Gross profit helps these businesses better understand their costs so that they can set the best pricing strategies for their products.

In contrast, businesses with lower direct production costs — such as service-based businesses or SaaS companies — tend to pay less attention to gross profit. For these industries, operating expenses are more impactful than production costs, so net profit provides a clearer picture of their overall profitability.

Regardless of your situation, it's important to evaluate both gross profit and net profit to get an accurate understanding of your finances and the viability of your business.

Financial metrics don't stop at gross and net profit. Most accountants will review other financial indicators that provide insight into a company's performance. These are some of the alternative approaches:

EBITDA (earnings before interest, taxes, depreciation, and amortization) evaluates a company's operational performance by excluding non-operational expenses, such as interest and taxes, and non-cash expenses, such as depreciation and amortization.

EBITDA provides an idea of the company's cash flow from core business activities.

Here's the EBITDA formula:

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

Here is the formula applied using the example tech company's income statement:

$250,000 + $15,000 + $35,000 + $10,000 = $310,000

EBITDA helps you understand the company's operational performance without the impact of financing decisions, taxes, 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.

Operating profit, or earnings before interest and taxes (EBIT), measures the profit from your core business operations. This excludes interest, taxes, and a few other non-operating income and expenses like investment income and gains or losses from asset sales.

Here's the operating profit formula:

Operating Profit = Gross Profit − Operating Expenses

Using the example tech company's income statement, here's the operating profit:

$600,000 − $280,000 = $320,000

EBIT is useful for finance professionals aiming to focus on core performance. Analyzing EBIT allows for more accurate comparisons of the financial performance of two or more companies, regardless of their capital structures or tax environments, which can differ due to external factors.

Also called earnings before taxes (EBT), this figure is a company's profit before income tax expenses are deducted.

Here's the pre-tax income formula:

Pre-Tax Income = Net Profit + Taxes

Lenders and investors often examine pre-tax income to gauge a company's profitability after accounting for financing costs, regardless of its tax environment. Taxes can vary widely depending on the taxing entity and tax elections made, so to determine the impact of debt, it's helpful to remove taxes from the equation.

Return on assets measures how well a company uses its assets to make a profit. It's expressed as a percentage, indicating the profit earned per dollar of asset owned. So, if your ROA is 15%, it means that your company made $0.15 in profit for every $1 of assets invested.

Here's the ROA formula:

Return on Assets = (Net Profit / Total Assets) × 100

If the example tech company had total assets worth $2,000,000, this is the ROA calculation:

($250,000 / $2,000,000) × 100 = 12.5%

A higher ROA shows you're using your assets more efficiently to generate profit. Again, this is especially important for businesses that have a large investment in equipment, such as those in manufacturing.

Operating cash flow shows how much cash a company generates from regular business activities. Unlike net profit, which can include non-cash items, this metric focuses only on the actual cash inflows and outflows during a specific period.

Here's the operating cash flow formula:

Operating Cash Flow = Operating Profit +/- Non-Cash Items +/- Change in Working Capital

Working capital is a company's current assets minus its current liabilities. Working capital may include assets such as cash, accounts receivable, and inventory, as well as liabilities like accounts payable, salaries, and taxes. If working capital is positive — that is, if its current assets exceed its current liabilities — it shows the company can meet its short-term obligations.

This metric matters for day-to-day operations. Even if a company appears profitable on paper, it may struggle if it lacks enough cash to pay its bills. Monitoring cash flow from operations helps keep the company solvent each month and able to fund its activities.

Relying only on gross profit and net profit won't provide the full picture. By also examining operating profit and EBITDA, you can understand how well the core business is performing and how much cash it generates from operations. Or if you compare pre-tax income (EBT) to net profit, you can find out how taxes are affecting the business. Reviewing these factors will help you decide if the company is a good 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 is true whether you're an outside investor, a manager in the business, a potential vendor, or any other stakeholder in the business.

Gross profit and net profit are two fundamentals for assessing different aspects of a company's financial performance. Gross profit shows production efficiency and cost management, while net profit provides a clearer picture of overall profitability. Both metrics help leaders make informed business decisions.

However, these two metrics alone aren't enough for a full picture. You can broaden your perspective by using other metrics, such as EBITDA, EBIT, EBT, return on assets, operating cash flow, gross profit margin, and net profit margin.