If you are looking to invest in shares of a company, you need to know how the company is doing. Is it profitable or not? This is why it is important to know the difference between gross profit and net income.
A company’s gross profit is the amount of money it makes in sales, minus the cost of goods sold (sometimes called COGS), says the federal government’s business advice website. The figure can also be referred to as gross income.
But gross profit does not take into account the operating expenses of a business.
This is why it is said that net profit can be a better indication of a company’s profit, as it takes into account the operating expenses of the company.
According to the Australian Taxation Office, operating expenses (also known as working expenses or income expenses) are the day-to-day expenses you incur to run a business. These could include things like rent, insurance premiums and advertising costs.
Example: Gross Profit vs. Net Income
The Government Enterprises website provides a simple example to illustrate the difference between gross profit and net income. (He actually uses the term net profit, but we’ll get to that later.)
In a typical month, a hypothetical business sells 30 products at $15 each. Each product costs $10 to produce. The operating fee for the month is $80.
From these figures, it is a simple calculation to calculate the gross profit and the net income of the company for this month.
Sales figure is 30 × $15 = $450 while cost of goods is 30 × $10 = $300
Gross profit = sales − cost of goods = $450 − $300 = $150
Net profit = gross profit − operating costs = $150 − $80 = $70
That’s an $80 difference between gross profit and net profit.
What profit figure should investors be looking for?
There are many ways for a company to report its earnings. As a potential investor, it is therefore useful to know which figure can give you a better indication of performance.
A good gross profit can indicate that a business provides goods or services that are in demand. It may also indicate that a business may be able to generate more gross profit if it can increase sales and reduce production costs.
But if you want to get a fuller picture of a company’s profitability, you also need to consider its operating costs. It’s good to produce something that sells at a profit, but not so good if those profits are eaten up by other costs.
Tom Delany, lecturer in tax law at the University of Southern Queensland, told Canstar the terms net profit and net income are used interchangeably.
“Net profit provides a better indication of profit because it includes the operating expenses (overheads) of the business and gives a more complete picture of the economic performance of the business,” he said.
Gavin Swan, member of CPA Australia and director of Absolute Accounting Services, agreed that net profit and net income mean the same thing: the profit remaining after paying all expenses, including overhead.
“The problem is there are too many interchangeable terms, some terms are investor-focused and some are American, and some are determined by the company you work for,” he told Canstar.
“Many places look at gross profit because many overhead costs are fixed, so the number that guides profitability is gross profit.
“As accountants and certainly in the tax area, we’re interested in net income because that’s closer to your taxable income and also what you’re able to distribute to shareholders.”
It is this potential for distribution of profits, paid out in the form of dividends, that could entice you to invest in a particular company. But remember that a company’s past performance is not always indicative of its future performance.
Obviously, there are other factors you should consider before investing in any business, and it might be a good idea to seek independent financial advice. But at least now you know the difference between gross profit and net income (or net profit).
Publication date: March 24, 2022
Cover image source: kangshutters/Shutterstock.com
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