“There’s a saying that turnover is vanity, and profit is sanity, and that applies just as much to net versus gross profit figures,” says business growth consultant Kevin Riley. “If you don’t understand your company’s net income, you’re operating blind and can’t understand if you’re truly profitable.”
Read on to learn more about how understanding the difference between gross and net is an essential building block for any successful business owner.
Gross vs net explained (with calculations)
In simple terms, gross is the whole figure, and net is what is left after deductions. In business, the terms are typically used when talking about gross profit and net profit, also called net income.
To accurately calculate both gross profit and net income, you must first understand the difference between direct and indirect costs.
Direct costs are those incurred in creating and selling a product to your customer. If the product isn’t made, the cost isn’t incurred. Direct costs commonly include things like raw materials, shipping, and packaging.
Indirect costs are those that your business incurs even if products aren’t being sold and are outside of core production costs. Also called operating costs or operating expenses, they can include rent, debt repayments and utility bills.
To calculate gross profit, you simply deduct the direct costs tied to making a product or delivering a service (e.g. labour and material costs) from your company's total income or sales.
“Gross profit is the difference between what the customer pays for a product or service and what it costs us to deliver,” explains Roy Shelton, Group CEO of IT supplier Connectus. “We track that, but it’s more important for us to understand the net income, which is what’s left after we account for all the costs. Net income is crucial in understanding if we are profitable and how much profit we’re generating.”
How to calculate net income
Net income - also known as the bottom line of a company's income statement - is the profit that remains after all expenses and costs have been subtracted from revenue, including operating expenses that are only indirectly associated with your product, and taxes.
A simple formula for calculating net income is shown below:
Net income = Gross Profit – Operating Expenses and Taxes
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Example of calculating the difference between gross and net
In the example balance sheet below, the company has a revenue of £500,000 and spends £320,000 on direct costs related to those sales, reflected on this balance sheet as costs of good sold (COGS). After deducting these costs, the company has a gross profit of £180,000.
However, the company also has indirect operating costs that include advertising, admin and insurance. In total these additional operating expenses total £159,400. Once they are deducted from the gross profit of £180,000, the balance sheet shows an operating profit of £21,600.
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However, this operating profit is before any taxes have been deducted. Once taxes of £4,100 have also been deducted, the bottom line net income is £17,500. This is less than a tenth of the top line gross profit of £180,000.
The above example shows how tracking net income gives a much clearer picture of the overall business performance than the gross profit figure.
Why are gross profit and net income important to your business?
Understanding gross profit and net income is important to businesses because it helps show whether a company is profitable. It is also a useful tool to help companies set the right pricing strategy, says Riley. If you track gross profit as a percentage, it provides a good idea of the viability of a product. But understanding net income – which accounts for all costs involved inbsviewallcards-basiccard-lea your business – helps to understand the viability of the wider business. “It’s an important way of understanding how to increase your sales price or boost productivity by paying a bonus, for example,” he says.
Abstract House supplies art and picture frames to customers via its website and through retail partnerships with the likes of TK Maxx and HomeSense. Having a good understanding of the difference between net and gross means that the company can maintain its pricing in the middle of the market, says Founder Summer Obaid.
“By looking at net income and gross profit, we realised that importing timber from Italy was more expensive than buying Italian timber in the UK,” says Obaid. By reducing spending on timber, the business invested in space to hold a stock of cardboard when prices were going up, while repurposing timber storage space as a retail showroom. "This meant we could reduce our overall materials cost and invest in using space as a retail showroom rather than for storing timber,” she says.
But understanding net or gross figures doesn’t have to be complicated or expensive, says Riley. “Every accounting package out there can generate reports that will give you this information in near to real-time. Don’t wait for your accountant to give you a report at the end of the year as you could be missing out on opportunities to grow and drive profits.”
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