Why Gross Profit & Net Income Are Important
In finance and accounting, gross profit and net income are two fundamental concepts that are crucial in evaluating a business's financial health and performance.
Both gross profit and net income are critical numerical values for every business since they serve as the make-or-break selling point for any investor, bank, and loan out there and are necessary when filing taxes. They also help monitor whether you're making or losing more money.
And while you might be tempted to use these terms interchangeably, it’s important to distinguish between them as it provides insights into various aspects of a company's operations, profitability, and overall financial success.
In this article, we'll delve into the nuances of gross profit and net income, exploring their definitions, differences, and applications in the finance and business realm.
To understand gross profit and net income, we must go more in-depth about revenue.
Revenue is the total money made from sales over a certain period, including physical products, digital wares, services, and anything else a customer might buy from a company. It's also known as net sales.
Revenue includes any discounts or markdowns a business may offer but doesn’t deduct taxes. Even though you may walk into the grocery store and buy a product for more than the price tag advertised, this tax is merely set aside for the business to pay separately and is included in revenue.
Here's a basic example:
Rob walks into the supermarket and sees an apple for $1. He buys five apples. After taxes, Rob pays $5.33. Thus, the revenue the business generates from Rob is $5.33.
The Cost of Goods Sold
The Cost of Goods Sold (COGS) is the direct expenses incurred by a business in producing or acquiring goods sold to customers. This often includes:
- The cost of the materials
- Expenses of equipment used for making the product
- Labor wages of the manufacturer's workers
- Shipping and handling costs
- Equipment repair cost
- Any additional fee charged by a manufacturer
Remember that the COGS doesn't include the costs of operating a seller's business. These expenses are deducted to get net income, which we will discuss further. COGS only includes expenses directly related to the making and delivering of a product.
It also doesn't include fixed expenses (expenses that don't change), such as rent costs, utilities, and insurance.
COGS primarily includes variable expenses such as shipping which fluctuate depending on circumstances. Since these costs are ever-changing, keeping track of COGS is essential.
The cost of goods sold is essential to calculating gross profit.
What is Gross Profit?
Gross profit is the money a company makes from its core operations after deducting the costs directly associated with producing or acquiring the goods or services it sells.
It gives insights into the profitability of a company's primary revenue-generating activities without considering other operating expenses, such as overhead costs, administrative fees, or taxes.
It indicates the amount of money available to cover operating expenses and contribute towards other business activities, such as research, development, marketing, or expansion.
To calculate gross profit, you only need to subtract the COGS from the revenue over a select period, such as a quarter.
You can use the formula below:
Gross profit = Revenue - COGS
Gross profit is a valuable tool that allows you to maximize production efficiency and make cuts when necessary. With it, you can also determine your net income, another important financial metric you must keep track of when managing a business.
What is Net Income?
At the end of the fourth quarter, when a business announces how much they made for that year, the number they'll provide is always the net income.
Net income, also called net profit, net earnings, or bottom line, is the total profit made after all expenses have been deducted. It includes the cost of production and all the expenses related to managing the business.
Some things this might include are:
- Selling, general, and administrative expenses (SGA expenses)
- Interest on debts (debt payments are often a fixed payment while interest isn’t)
- Cost of operation (electricity bills, rent, utilities, etc.)
Think of net income as the total amount of money a company actually has left over after the year instead of how much it made overall. When an investor evaluates a company's profitability, this number is often the first value they'll look at.
Calculating net income is merely subtracting revenue from your expenses, which is:
Net income = revenue - total expenses
Of course, you'll generally have these expenses already broken up, so it'll probably look more like this:
Net Income = Gross Profit - Operating Expenses - Interest Expenses - Taxes - Other Business Expenses
Positive net income shows that a company is generating profits, while negative net income, referred to as a net loss, signifies that the company's expenses exceed its revenue.
So, What's the Difference Between Gross Profit and Net Income?
Gross profit and net income are how much a company makes from sales but at different stages.
The first stage is revenue, which is how much a company makes from sales.
The second stage is gross profit, which deducts the cost of making and shipping said products to the business.
The final stage is net income, which adds up all expenses, including gross profit, and subtracts them from the revenue.
While gross profit is vital for calculating and evaluating production efficiency, it doesn't indicate a company's profitability.
On the other hand, net income is handy for determining profitability since it tells us how much money a company makes versus what they're earning on paper before expenses.
The Application of Gross Profit and Net Income
You might wonder: why is gross profit necessary when you can simply include it in your total expenses to calculate net income?
Breaking income into segments is helpful for different business functions and is much more advantageous than adding everything into one uniform value.
For instance, isolating gross profit can help business owners better identify the costs associated with production, compare them to the quality of products they receive, and make critical business decisions based on that.
These business decisions include producing new products, switching manufacturers, or changing designs.
And while gross profit is essential from within the business, net income is the most critical value you'll need for all external dealings.
- Submitting your income taxes: Remember, the government only looks at your net income, not your gross profit.
- Applying for loans and attracting investors: People and companies looking to invest in your business will do so based on your profitability or net income.
- Making business decisions: This category ranges over a broad matter of subjects and can include anything from increasing your employees' wages to halting the sale of a specific product.
In short, despite both values giving off different stages of profit, they're both essential for maximizing a business's efficiency.
Here are some frequently asked questions about gross profit and net income.
Which is higher, gross profit or net income?
Gross profit is always higher than net income since it's the money a company generates from its core operations after deducting the cost of goods sold (COGS).
The net income, however, includes additional expenses beyond COGS, such as administrative costs, overhead expenses, and taxes, resulting in a lower figure than gross profit.
Is net income before or after taxes?
Net income is the number you get after you deduct taxes. Gross profit and operating profit are both before.
Is 20% net income considered "good"?
Yes, 20% income is excellent, especially when you realize that the average for general retail is 4.38%.
What's the difference between gross profit and gross income?
Gross profit and gross income are the same. They are merely two ways of saying the same thing.
Gross profit and net income are two profitability-determining values that dictate many company decisions and highlight how much money they generate or lose overall.
While it can be easy to overlook gross profit since it's merely a cog in the greater scheme of things (aka net income), it's essential to keep a close watch on this value since you'll often need to go in-depth when looking at each aspect of a business.
By understanding the distinction between gross profit and net income, stakeholders can better understand a company's financial performance and make informed decisions regarding investments, pricing strategies, and overall business operations.
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