Gross profit is commonly misconstrued as the amount of money brought in by a company for its products or services. While the reality is slightly more complicated than that, gross profit is still the simplest type of profit for a business to calculate.
In short, gross profit is the difference in value between the revenue generated by a product or service and the cost of producing it. The latter is commonly known as 'cost of sales' or 'direct costs', and generally includes things such as materials, distribution costs and labour costs. In other words, gross profit represents the amount of value gained from the sale of a product or service.
However, gross profit doesn’t account for other costs, such as operating expenses (which are deducted to give operating profit) or other overheads, taxation, interest and payroll (which are deducted to give net profit).
Because gross profit doesn’t take these factors into account, it’s important to remember that it doesn’t represent your actual or ‘real’ profit. It’s entirely possible for your gross profit to show a significantly positive figure but for your operating or net profit to be low or even negative. However, this doesn’t mean that the calculation is useless.
Gross profit is useful for working out the value your business generates from its products or services. This can be used to decide if the profit margin for such products or services is acceptable, or whether changes will be needed, such as cutting production costs or raising prices. This is particularly useful as a first step towards making savings within your business. If your gross profit is satisfactory but you still need to make savings, then you know that any issues are arising from other costs such as taxation or overheads, which can then be identified using operating and net profit calculations.
Essentially, net profit is gross profit minus all the costs incurred in order to make that profit. When producing a profit and loss statement, net profit can be shown as a figure before or after tax.
For example, imagine a retail shop selling jewellery and other accessories that are bought from a wholesaler. The takings for the year in question are £200,000 and the cost of purchasing these items from the wholesaler is £130,000, thus the gross profit is £70,000. However, the shop costs money to run; there are heating and lighting costs, staff wages and associated taxes such as National Insurance payments, rent, business rates and insurance. If the total cost of all these things is £40,000, the net profit would be £30,000.
In the case of a single unit in a chain of outlets, there may well be a problem in assigning various costs proportionately between the various units. The chain will probably have a headquarters and its costs need to be allocated in order to get representative figures for the various units. The way in which this process is carried out varies between organizations.
Many businesses will use profit margin calculations to assess their performance, as well as a key performance indicator (KPI) to set targets. Thankfully, it's not too difficult to calculate both your gross profit margin and net profit margin.
Hopefully this has given you a better understanding of the difference between gross profit and net profit. For more information, why not take a read of our article on forecasting profit?