Gross Profit vs Net Profit

by Adarsh Raj Bhatt in August 3rd, 2021
man wearing white top looking at projector graph screen

TLDR

  • Gross profit is the calculation of the profit that a startup makes after the cost of production (or the cost of providing its services) is deducted from the total revenue that it earns. 
  • Net profit, also known as net income or net earnings, is another way of calculating a  startup’s profit. In calculating net profit, every type of expense (and not just COGS) will be subtracted from the revenue.
  • Gross profit is a mathematical way of understanding the spending efficiency of your startup. Through it, you will get a fair idea of how much your startup spends on production-related expenses like labor, equipment, raw materials, shipping, etc., to build its products (or its goods). 
  • Net profit can give you a more refined way of understanding how well your startup is performing. Other than including costs of goods sold, total expenses will also include every other form of your startup's expenditures -- including loans and income tax.
  • There are certain advantages to measuring the profits of your startup via its gross profit. Gross profit is easy to apply, time-saving, verifiable, reliable, and quite useful in budgeting. 
  • Similarly, there are advantages to measuring a startup’s net profit, which is an accurate way to calculate the overall profit that a startup makes. Startups with healthy levels of net profit stay in business longer, have access to low-cost financing (by reinvesting profits into their operations), enjoy increased company value, and are able to attract funding more readily.

What is Gross Profit?

Gross profit is the calculation of the profit that a startup makes after the cost of production (or the cost of providing its services) is subtracted from the total revenue that it earns. Gross profit is also sometimes known as operating profit. It is an essential piece of information as it gives invaluable insights into the operational efficiency of your startup. This includes labor, supplies, and income produced from the sale of your goods and/or services. Given its importance, gross profit is generally included in a startup’s income statement

Gross profit is calculated when the cost of goods sold is subtracted from the startup’s total revenue. In this case, revenue is the total amount of money earned from sales during a particular period. Sometimes, revenue is listed as net sales, which accounts for discounts and deductions due to returned or damaged goods have been deducted from the revenue.

Cost of Goods Sold, or COGS, is the cost of producing your startup’s goods and/or providing its services. 

COGS generally includes the following: 

  • Raw materials and inventory
  • Staff and their compensation
  • Cost of equipment 
  • Utilities for the production facility
  • Shipping costs

What is Net Profit?

Net profit, also known as net income or net earnings, is another way of calculating your startup’s profit. Net profit is generally used to assess the profitability of a startup during a given accounting period. In calculating net profit, every form of expense (and not just COGS) will be subtracted from the revenue. It is similar to gross profit but considers more factors for a more refined profit analysis of your startup. 

A startup's net profit value is generally reflected on the income statement and is extremely helpful to investors. This is because investors considering buying a startup’s stocks can refer to the value of the net income (or net profit) and assess the gap between revenue and total expense. This helps them make a more informed decision. Net profit is often referred to as the bottom line because it is always mentioned at the bottom of an income statement. 

Many factors should be considered when calculating your startup's net profit and will be based on the industry your startup serves. However, some expenses are common amongst most startups. 

The following is a list of some of these expenses:

  • Operating expenses
  • Interest in debt and loans
  • General and administrative expense
  • Income taxes
  • Depreciation, which includes the allocation of costs of fixed assets like equipment over their useful lives

How Does Gross Profit Work?

The formula to calculate gross profit is as follows:

Gross Profit = Revenue - Cost of Goods Sold

Gross profit is a mathematical way of understanding the spending efficiency of your startup. Through it, you will get a fair idea of how much your startup spends on production-related expenses like labor, equipment, raw materials, shipping, etc, to build its products or deliver its services.

This metric generally considers variable costs, which are costs that are known to fluctuate with the level of output. These variables include raw material, facility, shipping, etc. 

Therefore, gross profit steers away from including fixed costs in its calculation. Fixed costs are costs that must be borne by startups regardless of their output. These costs include expenses like rent, advertising, insurance, salaries, etc. There is an exception to this rule, though, that was developed within the scope of GAAP (Generally Accepted Accounting Principles). This exception is that a portion of the fixed costs must be included in external reports. 

One important use of gross profit is to calculate your gross profit margin, which is used to compare a startup’s manufacturing efficiency over time. Although both of these terms are used interchangeably, they are not the same. For instance, gross profit is represented in the form of money while the gross profit margin is represented in the form of a percentage.  

Gross Profit Margin is calculated as follows:

Gross Profit Margin = Gross Profit / Revenue

How Does Net Profit Work?

Net profit or net income provides a way for startups to calculate the profit that they are making per share. Following is the formula to calculate net profit:

Net Profit = Total Revenue - Total Expenses

Net profit can give you a more refined way of understanding how well your startup is doing. Other than including costs of goods sold, total expenses will also include every other form of expenditure that the startup bears, including loans and income tax. It is the bottom line that is used to measure, understand, and explain how profitable your startup is. 

Since net profit takes several variables into account, founders must be somewhat careful when making this calculation. Below is a more streamlined method for calculating net profit for startups: 

  • First, take your total revenue and subtract business expenses and operating costs from it. This will give you business earnings before taxes
  • Then deduct the taxes to arrive at the final net income.    

That’s not all ...

Net income is prone to fallacy through aggressive revenue recognition or misplaced/hidden expenses. Because of this, investors who decide to invest in a startup based on its net income value tend to assess the quality of the variables used to arrive at the final net income. 

Benefits of Gross Profit

There are a few advantages of measuring the profits of a startup via its gross profit. 

A few of these advantages are listed down below:

1. Easy to apply

Gross profit is one of the easier methods of calculating your startup’s efficiency. 

This is because it doesn’t require a lot of rigorous computation and accountants can use this value to extract other important information. For example, gross profit can be calculated by multiplying sales revenue by gross profit margin. Deducting gross profit from sales revenue will provide you with the cost of goods sold. Additionally, the difference between the cost of goods available for sale and the cost of goods sold will help you calculate ending inventory. 

2. Time-Saving

Gross profit is a favored method of calculating a startup’s business performance if time is of the essence and a physical count of inventory is not a priority. It is known to not only save time but resources as well. Gross profit calculation doesn’t require extra hands and your accounting department should be able to handle gross profit calculation. If there are no discrepancies, then gross profit value and a manual count should be the same.    

3. Verifiable and reliable

When conducting an audit of any startup, professionals rely on the gross profit method to verify the value of inventory held. Auditors will compare actual inventory count and gross profit value to look for any discrepancies. Even management is known to use this method when preparing financial statements for a given period. That shows how useful this accounting method can prove to be for more than one stakeholder.

4. Useful in Budgeting 

Startups are known for using values obtained from the gross profit method to make important budgeting decisions. The amount of inventory to be held is based on the estimated sales.  

Benefits of Net Profit

Net profit is a very accurate and sophisticated way to calculate the overall profit that a startup makes. The following are some of the advantages of net profit:

Keeps You in Business

A steady stream of profit will help your startup stay in business for a long time. It will help you to continue running your startup comfortably without facing any massive financial problems. If net profit starts to drop, on the other hand, you will have to look for additional sources of funding to keep your startup afloat. 

Low-Cost Financing

Net profit, when re-invested into your startup, can help create an internal cycle of financing which is created by your sales and the ensuing profits. This is a much cheaper form of financing without any involvement of external entities like angel investors and VCs. 

Increase Company Value

Net profit or net income is called the bottom line as it is generally written at the end of a financial statement. But it is also considered the bottom line as it can be used to understand the accurate value of a startup. Investors can figure out a startup’s value by multiplying the annual net profit with a market-designated multiplier. This multiplier is generally extrapolated from data from similar startups that were sold recently. 

Attracts Funding

An impressive net profit acts as a glowing beacon to attract investors. While large companies with decades of operations under their belt might not find this point interesting, startups and budding businesses that exhibit a steady rise in net profit in recent years will be considered prime candidates for banks and other investors. 

Limitations of Gross Profit

While gross profit is a helpful method in calculating a startup’s value, it comes with its limitations. The following are some common limitations of gross profit:

It doesn’t help in relative comparison

Startups that have taken years to scale and grow can boast a substantial gross profit compared to those startups that are lower on the ladder than them in this respect. However, this does not accurately represent the efficiency of the startup as much as it represents its size or scale. Therefore, gross profit cannot be used to conduct an apples-to-apples comparison of startups that function at different levels and markets. 

It doesn’t indicate financial health

Gross profit generally cannot be used to perfectly assess the financial health of any startup over time. 

For example, because the recent gross profit has not been up to the mark doesn’t conclusively signify deteriorating financial health or poor management. Similarly, an improved gross profit does not necessarily indicate improving financial health and/or better management skills. Rather than being analyzed individually, gross profit must be used in context with other contributing factors. Founders must also understand that gross profit per se signifies the startup’s profit and not its profitability, the latter being of more concern for the future growth of most startups.   

Limitations of Net Profit

Net profit is an important value for investors and startups alike as these values are continuously for comparisons between contemporaries. The following are some of the limitations of net profit

Debt reduces net profit

Many startups, especially the ones which have just begun to make a name for themselves, have done so by raising capital from various sources (e.g., loans, fundraising, and other means). If you were to calculate the net profit of a startup with higher financial leverage (amount of borrowed money) then the value would be surprisingly low even if their gross profit has been the highest in recent years. 

This is because debt, after being factored in during the calculations, reduces a startup’s net profit. 

Depreciation expenses

Not all startups provide the same product or service -- even the ones that provide similar products/services might develop them in quite different ways. 

Therefore, it is safe to say that some startups might require larger facilities and operational equipment to build their products when compared to other startups. These assets, called  Property, Plant, & Equipment (PP&E) assets lower the startup’s net profit by boosting the depreciation expenses. 

Profit Manipulation

As mentioned earlier (under “How Does Net Profit Work?”), the outcome of the net profit calculation is prone to fallacy and manipulation. 

In fact, founders can manipulate the system in such a way that the profit margin seems high on paper. A startup might reduce its spending on long-term expenses like research and development to show an increase in its net profit. This can only be done for a short period -- but it is long enough to mislead investors. 

The problem -- apart from the obvious ethical one? Experienced investors understand this potential for profit manipulation and regard it as a limitation of the metric, incorporating this know-how into their overall perception of net profit.

Citations

Gross Profit Definition

Net Profit Margin Definition

Understanding Net Income (NI)

Financial Statements Gross Profit vs. Net Income: What's the Difference?

The Advantages of the Gross Profit Method

Gross Profit - Importance and Limitations | How to Calculate Gross Profit?

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