Gross Profits Vs. Net Profits & Why They Matter

Published on
June 10, 2022
Written by
Zachary Pestana
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Episode #
Gross Profits Vs. Net Profits & Why They Matter
Gross profit, net profit & profit margins are extremely crucial for any business. Learn how to calculate them & how to increase your profit margins
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There's a lot of work that goes into building a successful business, such as:

  • building and refining your products and services
  • reaching product-market fit
  • ​hiring team members and employees
  • meeting up with potential investors
  • promoting your products with ads, endorsements, etc.
  • ​offering customer support after the sale, and
  • ​staying compliant with government rules

The aim of all those efforts is to become profitable.

Even if you're a non-profit that doesn't make money for its founders, you need to bring in more money (through sales, donations, etc.) than you spend to keep the lights on. That's why Wikipedia (a nonprofit) can spend $162 million per year and still stay profitable.

Why? Research suggests that roughly 80% of startups fail and the single-biggest reason (38%) was because they ran out of money.

Gross profits and net profits are two of the most essential business metrics that show you how healthy your business is by telling you:

  • ​if you're turning a profit and how much
  • how quickly you're growing (or losing) your initial investment, and
  • ​if you need to increase your prices, cut costs, etc.

What is gross profit?

Gross profit is how much you have left when you subtract the cost of goods sold (COGS) from the revenue you received from selling them.

It serves as a simple metric for quickly measuring your unit economics and the financial viability of a business idea. Simply calculate how much it costs you to produce a product (or a number of it, say 100 units) and subtract that number from how much you’re selling those products.

It helps you take a look at a product or service and quickly calculate if (note the word choice) you can turn a profit by producing that product for one price and selling it at another price figure.

For instance, let’s say you run a design agency and each freelance designer that works for you charges roughly $250 per deliverable.

If a client pays you $5,000 for ten designs per month ($500 per design) your gross profit will be $250 per asset delivered or $2,500 per month.

What is net profit?

Net profit is how much money you have left after paying all your operating expenses, including the cost of goods sold (COGS), taxes, salaries, benefits, commissions, etc. from your revenue.

Net profits are a more reliable way of measuring your company’s financial health since it shows how much money you made over a particular period of time.

Net profits can either be positive or negative, in which case they’d be net losses.

Calculating net profit starts with asking questions like:

  • How much did we make on all the products we’ve sold this month, quarter or year?
  • Are we losing money?

Why do you need to calculate your gross profits and your net profits?

If your net profits can offer you better insight into your company’s financial health, why bother calculating gross profits?

The reason why is simple: gross profits are a quick, rough way of measuring if you can make profit by creating a product for, say, $100 and selling it for $125; it doesn't consider other factors like how much you will spend on customer support, refunding customers if they don't like the finished product, paying taxes, renting an office, etc.

Net profits show your company’s big picture financial health while gross profits are useful for quick estimates.

How to calculate gross profit

The gross profit formula works like this: subtract the Cost of Goods Sold (COGS) from how much you sold it for (i.e. your revenue).

  • Gross profit = Revenue - COGS

For example, let’s say you run an online store that resells shoes. You buy 100 pairs for $30 each ($3,000 total) and resell them for $50 each. Using the gross profit formula, your gross profits will be equal to:

  • $50 * 100 - $3,000 = $2,000

How to calculate net profit

The net profit formula goes as follows: subtract your total expenses (COGS, salaries, raw materials, software subscriptions, benefits, etc.) from your total revenue for the period of time you’re calculating for.

  • Net profit = Total Revenue - Total Expenses

For example, let’s say a software company has 10,000 customers paying $10 per month for their product (i.e. $120 per year).

Their total revenue is equal to $1.2 million per year and their expenses are as follows:

  • Salaries & benefits: $400,000
  • Rent: $206,000
  • Taxes: $150,000
  • Hosting & servers: $101,000
  • Web development & support fees: $98,200
  • Payment processing fees (2.9% of every transaction): $34,800
  • Professional services & training costs: $110,000
  • Miscellaneous: $100,000

In total, that’s $750,000 spent on operating expenses in the same year, and so, using our net profit formula, their net profits will be equal to:

  • $1,200,000 - $750,000 = $450,000

What are the differences between gross profit and net profit?

Here’s a table that highlights the differences between gross profits and net profits to help you understand how knowing each one can influence the financial health of your business.

What is gross profit margin?

Gross profit margin measures your profitability by showing your gross profit as a percentage of your total sales. It answers the question: by how much did our revenue exceed the cost of producing these products or services?

How do you calculate gross profit margin?

The gross profit margin formula goes as follows:

  • Gross profit margin (GPM) = Gross profit/Revenue *100

Back to our gross profit example: our ecommerce shoe store owner makes $2,000 in gross profits on revenues of $5,000. Using our gross profit margin formula, the business’s gross profit margins will be:

  • ($2,000 ÷ $5,000) *100 = 0.40 * 100 = 40% or 2:5

What is net profit margin?

Net profit margin is a ratio that measures what percentage of profit you’re making on all the goods and services you’re selling.

While your net profits can show you how much money you’re making or losing, your net profit margins tell you how quickly you’re growing or losing your working capital.

For instance, if you spend $1.25 million on expenses (COGS, salaries, taxes, etc.) in a year and make $125,000 in profit. You’re growing your capital at a 10% rate. 

How do you calculate net profit margin?

The net profit margin formula is as follows:

  • Net profit margin (NPM) = Net profit/Revenue *100

Again, in our earlier example, the software company makes $450,000 in net profits on revenues of $1.2 million. Using the net profit margin formula, the company’s net profit margin will be:

  • ($450,000 ÷ $1,200,000) *100 = 0.375 * 100 = 37.5% or 3:8

How to increase gross profit margins and net profit margins?

The aim of running a business is to bring in profits.

Higher profit margins will help your organization withstand business challenges, hire more employees, invest in new product lines, and take some money off the table to spend on your personal needs.

Increase prices

Increasing your prices is the easiest way to bump up your margins, as long as you don’t drive away your current customers.

Hiking your prices aggressively will bring in more revenue per sale but can ultimately hurt your profits by driving away customers.

Instead, you can markup your prices gradually, offer a bonus item, and increase the perceived value of your products with better branding.

Cut down on production costs

Whether via managing expenses more carefully or negotiating with suppliers so you can reduce your accounts payables.

Increasing your profit margins starts at production: if you can produce high-quality products for a reasonable price you can sell those to your customers at a decent markup, without looking overpriced.

Cutting down production costs can happen in the form of:

  • Talking with your suppliers to give you volume discounts
  • Contracting out any parts of your production that you can’t do efficiently enough in-house,
  • Renegotiating and saving money on (accident and risk) insurance,
  • Using labor-saving technology to increase productivity and get more work done, and
  • Buying affordable raw materials

Reducing costs can also take the form of managing expenses carefully as also by minimizing your accounts payables.

Outsource and use freelancers, contractors, etc.

When you factor in training, payroll taxes, insurance, benefits and office space, full-time employees can cost anywhere from 1.3 to 1.6 times their base salaries. On the other hand, contractors and freelancers often master their economies of scale better and charge a fixed price for the work quoted.

Full-time employees are perfect for roles where the job description is flexible and a lot of initiative is needed. Outsourcing work to contractors and freelancers is often ideal when you have fixed requirements that you can pay a fixed price for.

This explains why companies like Apple and Samsung contract out a huge portion of their supply chain, product assembly, etc. so they can focus on branding and sales —the main areas that drive the bulk of their revenue.

Build strong brand loyalty

Research suggests that loyal customers are 59% more likely to choose your products over competitors.

You don’t need to look too far for the evidence: brand loyalty explains why Apple customers routinely buy iPhones ($1,000 on average), Airpods ($100 — $500), and iMacs ($1,699) instead of Android phones (starting at $100) generic earbuds, or Windows, Linux, and Chromebook computers (starting at $300 - $500).

Your branding can include things like offering return customers exclusive discounts, sending them store credits, bonus products, gifts, etc. 

Manage your business finances better using Aspire

One of the easiest ways to increase profit margins is managing the controllables efficiently. These include controlling your costs via effective spend management, ensuring healthy cash flow via streamlined receivable management and payable management solutions etc.

Aspire offers you a range of solutions to manage your finances better. As the old saying goes, “a penny saved is a penny earned.”

For more episodes of CFO Talks, check us out on Apple Podcasts, Google Podcasts, Spotify or add our RSS feed to your favorite podcast player!

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Zachary Pestana is a seasoned writer in market trends and business thought leadership. With a writing history at Incorp Global, MOQdigital, and AIESEC Australia, Zachary leverages his broad range of experiences to stimulate industry conversations and engage audiences.
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Aspire is the all-in-one finance operating system for businesses. Our mission is to empower the next generation of entrepreneurs with the financial tools they need to realise their company’s full potential.
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