Gross Profit vs Net Profit: Are you making any money?

There is a lot of talk about profit in business. It’s what we all want to make, so there’s no surprises there.

But, what profit are we talking about?

Gross profit or net profit? They are both very important metrics, but very different at the same time.

Gross Profit is what you make directly after making a sale and deducting the costs of making that sale from the sale price….

Where as Net Profit is what you make after deducting all of your overhead expenses from your Net Profit…

Let me explain.

Your business has costs. These costs can be split into two categories: direct costs, and overheads.

Your direct costs are those that you incur directly, in the course of making a sale. For example, if you sell cars, the cost of purchasing the car from the wholesaler to then sell to your customer is one of your direct costs.

So, your gross profit is then the price you sell the car to your customer for, less the cost to purchase that car from YOUR supplier.

With that gross profit that you’ve made, you can now pay your OVERHEADS, which might include office rent, your staff salaries, consultants etc.

Your overheads are the costs not directly attributable to the sale of the car but are still necessary to keep the lights on and the business in action.

That leads us to your Net Profit.

This is what’s commonly referred to as your ‘bottom line.’ It’s your gross profit, less your overhead expenses.

Any net profit the business earns, can be utilized by the business to grow, invest, or be paid out to it’s owners in the form of dividends or increased salaries.

Operating Leverage

Overheads are usually fixed. That is, they don’t change much month to month, year to year. For instance, your office rent is not going to wildy fluctuate month to month, it will stay the same, as per the lease agreement.

That generally means, if you increase your sales revenue, most of that increase will fall to the ‘bottom line’ because your overheads did not increase along with the sale…

Let me explain.

Say you are running a business and this business in the last 12 months had $100k of sales, $20k of direct costs, and $20k of overheads; meaning a gross profit of $80k, and a net profit of $60k.

Now, you want to increase your bottom line by $20k, taking it from $60k to $80k.

Given your gross profit margin of 80% ($80k gross profit divided by $100k sales), your business will need to sell $25k of products or services to earn that additional $20k in gross profit (with an 80% gross margin, it costs $5k to make that additional sale).

But, remember those overheads. Since they didn’t change (because you didn’t need to go and lease a new office space to make the additional sale), that additional $20k in gross profit falls straight to the bottom line.

It literally by-passes the overheads!

Your net profit is now $80k.

Another way of thinking about it is that for every $1 of sales revenue you make over and above $100k, you get to keep 80 cents.

The net profit margin on the sales revenue from $0 to $100k is 60% or 60 cents for every $1 of sales revenue, because you needed to incur those overheads to make that sale.

How to tell if your business is in good shape?

Assuming all else is held equal, the business is not in financial distress and doesn’t have large liabilities, you should focus on your Gross Profit FIRST and Net Profit LAST.

That’s because you need to make a healthy gross profit before you can even consider paying your overhead costs.

If your gross profit margin is not allowing you to pay your overheads, then your business will be struggling.

And that makes sense right, because you need to be profitable on a sale-by-sale basis, before you can be profitable as a whole.

Gross Margin vs Markup

Don’t get confused with the two. They are very different.

Your gross profit is what’s left after making the sale and deducting the costs of making that sale.

Your gross margin is your gross profit expressed as a percentage of your sales. 80% in the above example.

Your MARKUP is how much you ‘mark-up’ your direct costs to arrive at your sale price.

For example, if the car I bought from the wholesaler cost the business $10k, and I want to sell it for $25k, then my mark-up is 250%.

Whereas your gross margin would be 60%; $15k profit divided by a $25k sales price.

(P.s. The cover photo for this article is that of me scratching my favourite local kitty, Cheeto. He is super friendly and we often run into him while walking in our local parker here in Hobsonville Point, Auckland).