What is Gross Profit and Net Profit?
Gross profit is the difference between revenue and cost of goods sold divided by revenue. It speaks to efficiency and success in the marketing and sales department and gives a business owner a sense of “Top-line Sales”.
Net profit is the revenue remaining after all operating expenses, interest, taxes and preferred stock dividends have been deducted from a company’s revenue. Net profit is also referred to as “Bottom Line” profit, showcasing efficiency in cost of goods sold as well as supply chain, distribution, human resources, accounts receivable and loss factors.
Note: When referred to as gross profit margin or net profit margin, it’s relation as a percentage of revenue is being discussed (i.e. 30% net profit margin). Without margin, it’s referring to the absolute number.
Why does Gross Profit Margin Matter?
Understanding the difference between gross profit and net profit allows a business owner to gain insight into two distinct parts of their business.
Knowing your profit margin is important to understanding how efficiently your company is using its raw materials and labor used to produce those goods and services.
Calculating your gross profit also allows you to compare your margin to the industry to see how your business is doing against similar companies.
How do I Calculate my Gross Profit Margin?
The gross profit margin calculates your gross profit, alternatively the formula used to calculate it is very simple. (total revenue – cost of goods sold/ total revenue) x 100 = gross profit margin % (all of which can be found on income statement). This is the best way to measure the profitability of your business.
What is the Gross Profit Margin Formula?
Now, you’re probably wondering why you have to change the dollar amount to a percentage, right? Investopedia suggests that using percentages is better for historical company data to measure how profitable your company is.
(Gross Profit/Revenue) x 100 = Gross Profit Margin %
For example: Say you own a golfing supply and equipment company and your total revenue from sales is $15,000 for a quarterly period, and your cost of products sold is $10,000, this includes all necessary direct costs you will likely incur during this time period. Your gross margin would look like this:
$15,000 – $10,000 = $5,000
Your gross profit margin is currently at a dollar value, to convert this into a percentage value we would need to divide $5,000 (which is your gross profit margin) by total revenue then times 100.
($5,000/$15,000) x 100 = 33.3%
On average the higher your gross margin percentage the better. However, it varies from company to company/ industry to industry. Your gross profit margin tells a story and a number of 33% can show that you are more efficient in the distribution of supplies than your competitors.
Why is my Gross Profit Important?
You want to know how our business is performing, correct? Well, it’s important to track your gross profit margin month to month in order to track any changes in the industry or mark any red flags. This could mean that if there is a change in your gross profit margin, the percentage you have can give insights on issues with your company or jobs.
To get more specific, your gross profit margin provides insights on:
- cost overruns
- poor pricing decisions
- profitability trends
- profitability against the company/industry
Why does Net Profit Margin Matter?
If you don’t have a positive net profit margin, it means your business is spending more money than it makes. It’s used as a gauge by the public markets and private investors when assessing the value of a company. For example, if a company has a net profit margin of 30 percent, it means the company makes 30 cents of profit for each dollar of sales.
How do I Calculate my Net Profit Margin?
The formula for this calculation is revenue minus cost of goods sold, operating expenses, other expenses, taxes, and interest (total expenses). Also, divided by total revenue and multiplied by 100 to get the percentage margin.
What is the Net Profit Margin Formula?
Net profit margin = (net income/ total revenue) x 100
Your profit margin can be either positive or negative. Negative indicating that your company failed to be profitable during a specific time frame. Positive meaning your company is profitable, the more successful your company is, the more successful your bottom line is.
For Example: You have a cookie stand and sell your cookies for $1 and you sold 10 cookies, you made $10, Nice! buying all your ingredients such as flour, sugar, and eggs cost you $5, what’s your profit margin?
$10 total sales – $5 cost of goods sold (COGS) = $5 net income profit
$5 net sales/ $10 total sales = 0.5 x 100 = 50% net profit margin — nice!
Why is my Net Profit Important?
Your net profit margin is a good indicator of overall company profitability because it shows what percentage of each dollar of revenue the company ends up keeping as profit.
It’s important to know what your profit margin is to focus on your final finance results. This also helps you to understand why or how your increase in revenue isn’t always equating to an increase in profit.
How Relevant are Profit Measurements?
You may tell yourself gross profit isn’t that important, but the fact of the matter is you need both calculations to determine the profitability and overall health of your company as well as your standing in the marketplace.
According to Quickbooks, “Gross Profit indicates efficiency with which a business makes use of its labor, raw material and other supplies.” It determines the amount of money you actually have to cover operating and non operating expenses. A high gross profit ratio to revenue could mean a few things:
- The operating cost is relatively low
- Revenue has increased but operating costs remained the same
- Operating costs are low but revenue remained the same.
However, a low ratio of gross profit can indicate that your company isn’t in a good place, such as:
- The profit being low
- Operating costs being too high
- The revenue income is low
On the other hand, net profit is important for stakeholders, especially when they talk about your “bottom line.” A good rule of thumb is as this number goes up, it will make your company more attractive to shareholders, investors, and partners.
Is there such a thing as a “Good” Profit Margin?
What’s the golden number? In reality there is no exact number that qualifies as a “good” profit margin. Alternatively, it all comes down to what industry your company is in. However, it is said that a profit margin that is between 10%-20% is the golden rule for having a healthy business.
The best way to determine a good profit margin is to check with your competitors performance and industry trends.
You’ve made it this far and now know the key differences between gross profit and net profit.
While gross profit is useful for measuring the value your company generates from its products and services, net profit will tell a person how efficient his or her business operations are.
There are two types of profit margins and formulas for them that are useful in determining your company’s overall health:
- Gross Profit Margin = (gross profit/ total revenue) x 100
- Net Profit Margin = (net income/ total revenue) x 100
These two are important factors for your business, and while there is no overall golden number for a “good” profit margin, you can compare your competitors performance as well as industry trends to determine what a “good” margin is for YOU.
For more helpful financial tools, visit the Biz2Credit financial calculators page.