Gross profit, net income, potato, potahto, right? Wrong. These figures are often confused for one another, but they are incredibly different in their calculation and their use for your business.
For example, you know that payroll expenses for your small business should be around 30% of your net income… or wait, was that 30% of your gross profit? These two concepts are so closely intertwined that it can be challenging to remember which is which.
However, to ensure the success of your small business, you must understand gross profit vs. net income: The differences between them and the importance of each figure.
We’ll cover the differences between gross profit vs. net income. By the time you reach the end of this article, you’ll better understand each figure and how it impacts your business.
Gross Profit vs. Net Income: Why You Need To Know The Difference
Financing struggles are the number one reason small businesses fail. Lack of funding is an issue, but worse is the lack of working capital because you don’t know your numbers. Without understanding your business’s profitability, you’re setting yourself up for failure.
How can you take action if you don’t know how to read financial statements or what the numbers mean? You can’t create a plan for profit without knowing how much revenue you’re generating, the profit you’re already making, and the costs of operating your business.
It can be incredibly empowering to know your numbers and plan for the year ahead.
ConnectPay has you covered when it comes to payroll. We help small businesses stay compliant and correctly process their employees’ paychecks. Take a look at the problems we solve to see how you can take the stress and hassle out of payroll to focus on growing your business.
Gross profit is the profit a company makes once the costs associated with making its product or providing its services are deducted.
Making a product or providing a service and the associated costs are often described as the cost of goods (or services) sold. The cost of goods sold is sometimes abbreviated to COGS. It’s important to note that gross profit generally includes
To calculate gross profit, you subtract the cost of goods sold from revenue (sales) made on the products or services sold.
Gross profit = Revenue - COGS
You might also see the term net sales on reports and wonder what the difference between revenue and net sales is.
Net sales are calculated by subtracting sales returns, allowances, and discounts. The costs associated with net sales affect gross profit.
Importance of Gross Profit
Gross profit highlights how efficiently a company uses its workforce and resources to produce its goods and services. Variable costs are associated with production, such as materials, labor, commission, and shipping. It’s important to note that gross profit generally includes variable, not fixed costs (you’ll see why later!).
Gross profit will often fluctuate, and businesses should notice when it does. If it increases, what are you doing right? If it decreases, what’s going wrong, and how can you take corrective action?
There are certain things to look out for. Maybe changes in the product have changed the cost of production. Perhaps there’s a lack of efficiency in the company's day-to-day running. It could be as simple as the cost of materials going up. But it’s crucial to keep an eye on these numbers.
For a general overview, you might track sales over time and use reports to see what’s selling at what times of the year so you can forecast and make adjustments to production or marketing efforts. You could also track employee sales quotas and provide incentives to increase sales and revenue.
Example of Gross Profit
Let’s say you have a small business, like a restaurant. All you sell is one dish: avocado on toast.
How much are you making on each plate of avocado on toast? You sell each plate for $5, and you sell 350 plates a month. You have $1400 revenue.
After subtracting how much it costs to produce 350 plates of avocado on toast, you’re left with a gross profit of $980. You can use that money to pay fixed expenses and pay your salary.
Remember when we said it’s important to note that gross profit generally includes variable costs? Here’s why.
Net income is calculated as revenue (sales) minus the cost of goods sold and fixed costs such as selling, general and administrative expenses, operations, interest, and taxes.
Net Income = Revenue - Total Expenses
It’s often referred to as the bottom line on an income statement.
Importance of Net Income
Net Income is used to determine the profitability of your business.
Without it, you don’t know if you’re making a profit. You may have brought in $100,000 last quarter, but if you’ve put out $101,000 in business expenses like salary, building lease, and other costs, your business hasn’t made a profit.
You can see why it’s slightly more important than gross profit. Going off gross profit, you might think you’re doing well, but if you haven’t factored in operating expenses, you don’t know the true health of your business.
Net income can also be used to compare performance over periods of time. You might want to track business growth and financial performance from year to year. If your net income stays the same for three years or gets worse, maybe you need to cut expenses or sell more products. You know you have a healthy business if it grows year on year.
Related Read: 9 Human Resources Solutions for Growing Businesses
Example of Net Income
Using our example of the restaurant owner from earlier:
We know they have a monthly gross profit of $980. But what if their fixed costs like rent, insurance, and other operating expenses come to $1000 per month? The business isn’t profitable.
The owner would need to either sell more plates of avocado on toast or reduce operating expenses. With this example, it’s easy to see why it’s essential to know these numbers and the differences between them.
Gross Profit vs. Net Income: Only The Beginning
As a small business owner, you know how important it is to keep your finger on the pulse of your company’s resources. It’s essential to consider your business’s cash flow and your human resources.
Employee payroll is a significant expense for most businesses, and making payroll processing errors can result in fines that will dig even further into your bottom line.
ConnectPay is dedicated to providing support to small businesses. Our Connected Guide to Small Business Payroll eBook gives you an in-depth look at the pillars of a successful payroll operation. Start as you mean to go on!