Gross vs Net Income: How They Differ and Why They Matter

  • Accracy
  • 26th Nov, 2023

How much money did your business make last year?

Gross vs Net Income: How They Differ and Why They Matter
Accounting

What is gross income?

Your business's gross income, or gross profit, is measured by how much revenue you make in sales, less the direct cost of making your product (called cost of goods sold or COGS) over a period of time.

Gross income = Revenue - Cost of Goods Sold (COGS)

Gross income helps you understand how much profit you've made without accounting for operational expenses, like rent or office supplies—it's the money you've made on the sale of your product alone.

What is revenue?

Revenue is the money your business generates. You might consider it the opposite of expenses, which is the money that goes out the door in your small business. You can also correlate revenue with gross pay on a paycheck before any deductions are made. You'll find revenue on the top line of your income statement.

If you're in the business of selling apples, for example, customers may pay a dollar for each apple they purchase. Your revenue is the collection of dollars you have at the end of a market day.

While revenue alone isn't the only measure of your financial health, it's a good starting place for further financial calculations and can help you spot trends.

Note: It gets a little trickier when we start to talk about gross revenue, which includes all income generated by a sale, and net revenue, which subtracts adjustments like refunds, returns, and discounts from that income. For simplicity's sake, our example uses gross revenue.

 

What is Cost of Goods Sold (COGS)?

Cost of Goods Sold or COGS is how much money you spent making or acquiring any goods sold during your reporting period. Like revenue, you'll find COGS on your income statement.

COGS can include things like:

  • The cost of inventory and packaging material
  • The value of your labor
  • The cost of raw materials that are directly related to producing and selling goods

There are a few things to remember when calculating Cost of Goods Sold, though:

  • COGS is based on products sold, not products you still have on hand. If you've got inventory still on the shelves when the reporting period ends, you wouldn't include the cost associated with producing those unsold goods.
  • COGS includes direct production costs, not overhead expenses like rent or insurance.

In the apple-selling example above, those apples don't just magically appear at the market. Instead, you must acquire them and prepare them for sale.

In this case, COGS would include the price you paid the farmer for your raw materials (aka apples )—but only the ones that sold.

How to calculate gross profit

Remember that equation from before? Here's where you'll use it.

Once you have your revenue and COGS numbers, it's simple to find the gross profit: just subtract the COGS from your revenue. The difference is your gross profit.

Gross income = Revenue - Cost of Goods Sold (COGS)

If your apple business generates $400 in revenue, but you spent $100 on the apples, your gross income is $300.

What about gross margin?

Gross margin is very similar to gross profit or gross income, except you're dealing in percentages instead of dollar amounts. Gross profit margin gives you the percentage of sales revenue that exceeds your Cost of Goods Sold.

To calculate gross margin, you divide gross profit by revenue, then multiply the resulting decimal by 100. Here's the equation:

Gross margin = ( Gross profit / Revenue) x 100

Your gross profit margin reflects how successful your company is at generating revenue, considering the costs it takes to produce your products or services. The higher your gross margin, the more efficient you've been in generating profit for every dollar of cost involved.

If an apple costs you $0.25 but you're able to sell it for $1, the apple has a gross profit margin of 75%.

What is net income?

Net income, or net profit, is what's known as your "bottom line"—perhaps unsurprisingly, you can find it at the bottom of your income or profit and loss statement.

Net income is the total amount of money that your company earned in a period less all business expenses. Unlike gross income, which only deducts COGS from revenue, net income tells you how much money your business has earned after every business expense has been paid.

What are typical business expenses used to calculate net income?

While calculating your gross income only requires your COGS and revenue numbers, net income is a little more complicated.

Typical business expenses used in net income calculations include:

  • Operating expenses like rent, maintenance, and utilities
  • Interest on any business loans and debts
  • Overhead and administrative expenses
  • State and federal income taxes
  • Depreciation for fixed assets, calculated over the useful life of those items.

While you use more expenses to calculate net profit than you do for gross profit, your definition of "income" gets a bit broader as well.

In addition to revenue from selling goods and services, net profit may also include proceeds from investments and profits from the sale of business assets as well.

How to calculate net income

Your business may be making a killing on every item it sells, but if you are spending too much on other areas of your company, you may still be losing money or "in the red." A company is only profitable if its net income is positive or "in the black."

The formula to calculate net income is:

Net income = Total revenue - Total expenses

In practice, this looks like tallying up all your revenue, including any money you made from selling assets or investments. Then, total up all the expenses you had for your company, including every dollar spent on marketing, each annual salary, health insurance, IRS taxes, Social Security payments, rent payments, and other necessary costs.

Subtract the sum of all expenses from the sum of all revenue. The answer you get is the net profit or the net earnings of your business.

Hopefully, it's a positive number since it's your company's bottom line. If you find your net profit is negative, it means your business expenses are higher than your revenue, and you are currently operating at a net loss.

What about net margin?

Net profit margin, or net margin, is the ratio of net profits to revenues. You can use net margin to see how much of every dollar you collect in revenue becomes profit for your company.

Here's the equation:

Net profit margin = ( Net income / Revenue ) x 100

Net margin is considered one of the most important indicators of a company's success and profitability. Business owners and investors track net profit margin over time to assess how well the business practices are working and to predict changes in profitability.

Net profit margin can be a better indicator of success than gross profit margin since it includes all costs associated with bringing a product or service to market, not just COGS.

In our gross profit margin example, we said that an apple costs $0.25 in COGS, and you were able to sell it for $1, so your gross profit margin was 75%.

But what if we add in the cost of flyers to advertise your market stall and repairs on your apple cart? If those costs average out to an additional $0.40 per apple, your net profit margin is now 35%. You're still making money, but not quite as much as your gross profit margin might seem to indicate.

What do gross income and net income tell you?

Gross income measures the health of your sales and the associated production and labor costs. Since gross profit is calculated using key sales numbers, it's useful for business owners when monitoring how profitable each sale is or could be. Lenders also use gross income when making loan approval decisions.

If there is an increase in the price of raw goods, for example, your gross income will go down if you don't also raise prices to accommodate the increase in the Cost of Goods Sold.

Net profit, on the other hand, includes more metrics about your business. In addition to measuring sales, net profit shows efficiently your business is running to make those sales.

When compared to gross income, net income can show you if you are undermining your healthy sales with inflated overhead costs or if you need to adjust your prices to better accommodate the tax burden your company is expected to pay.

Depending on which numbers you use, you can easily go from celebrating a very healthy business income to not seeing any income at all. Understanding the difference between gross vs. net profit can make a dramatic difference in the way your business is evaluated.

Gross vs net income: an example

Let's look at an example of a fictitious company.

Here are the high-level numbers that Greenlife Apples is working with:

Revenue: $1,000,000
Cost of Goods Sold: $250,000

Gross income and margin

Knowing the revenue ($1,000,000) and COGS ($250,000), we can calculate that the gross profit for Greenlight Apples is $750,000.

We can also calculate the gross margin. (Remember, that's gross profit divided by revenue, multiplied by 100).

($750,000 / $1,000,000) x 100 = 75%

According to these calculations, Greenlight Apples is doing rather well with bringing its goods to market. They are making far more in revenue than they are spending to sell each item.

Net income and margin

Greenlight Apples also calculated that the company's total expenses, including factors like overhead, taxes, interest payments, and administrative and operating expenses, are $1,200,000.

Greenlight Apples also did not make any additional asset or investment sales. With no other sources of income, the total revenue remains $1,000,000.

To calculate the net income or profit for Greenlight Apples, we subtract total expenses from total income.

$1,000,000 - $1,200,000 = -$200,000

Greenlight Apples has been losing money this year, and they are currently operating at a loss. For this period, the company has spent $200,000 more than it has made—not a healthy sign for the owners and managers of the business.

Next, we'll calculate net margin by dividing net income by revenue and multiplying by 100.

(-$200,000 / $1,000,000) x 100 = -20%

With a negative net margin of -20%, this should be a call to action for Greenlight's business owners. Adjustments will need to be made for the company to regain profitability.

When you consider that the gross margin was 75%, we know that sales were very healthy and balanced. This means that the problem is somewhere in the other expenses. Salaries or marketing expenses may be too high, or high rent for a premium location may be bleeding a company dry.

However, a negative net income or net margin isn't a death toll for a company. In some cases, companies expect losses over the first months or even years of operating due to high start-up or overhead costs. High initial marketing costs might fuel greater customer retention down the road, boosting revenue long-term and balancing initial expenses with healthier margins over the longer term.

Running these calculations can help stakeholders in Greenlight Apples understand more about the financial health of their business and any levers they can pull to increase profits.

How Accracy can help

As a business owner, it's important to know your numbers. You need to know if every sale you make is profitable or if overhead is smothering your healthy sales.

The numbers that help you make better financial decisions come from reliable bookkeeping.

That's where Accracy can help. Our dedicated team of bookkeepers and financial experts automatically import your transactions and categorize them for you, generating up-to-date financial statements that are ready for you at any time. We can even help you file your taxes at tax time! Learn what bookkeeping with Accracy is all about.

 
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