The terms "profit" and "income" are often used interchangeably in day-to-day life. In corporate finance, however, these terms can have very different and specific meanings, depending on the context in which they are used.
While income does mean positive flow of cash into a business, net income is something much more complex. Profit is generally understood to refer to the cash that is left over after accounting for expenses. Though both gross profit and operating profit fit this definition in the simplest sense, the kinds of income and expenses that are accounted for differ in important ways.
- Gross profit is the total revenue minus the expenses directly related to the production of goods for sale, called the cost of goods sold.
- Derived from gross profit, operating profit reflects the residual income that remains after accounting for all the costs of doing business.
- Net income reflects the total residual income that remains after accounting for all cash flows, both positive and negative.
Understanding Net Income, Gross and Operating Profit
Gross profit, operating profit, and net income are all types of earnings that a company generates. However, each metric represents profit at different parts of the production cycle and earnings process. All three financial metrics are located on a company's income statement and the order in which they appear help show the relationship to each other and their importance.
The top line of the income statement reflects a company's gross revenue or the total amount of income generated by the sale of goods or services. From there, various expenses and alternate income streams are added and subtracted to arrive at the various levels of profit.
Gross profit is the total revenue less only those expenses directly related to the production of goods for sale, called the cost of goods sold (COGS). COGS represents direct labor, direct materials or raw materials, and a portion of manufacturing overhead that's tied to the production facility.
COGS does not include indirect expenses, such as the cost of the corporate office. COGS is a key metric since it directly impacts a company's gross profit, which is calculated as follows:
Gross profit = Revenue - Cost of Goods Sold
Since COGS represents the cost of acquiring inventory and manufacturing the products, gross profit reflects the revenue left over to fund the business after accounting for the costs of production.
While gross profit is technically a net measurement of profit, it is referred to as gross because it does not include debt expenses, taxes, or all of the other expenses involved in running the company.
Next on the income statement is operating profit. Derived from gross profit, operating profit reflects the residual income that remains after accounting for all the costs of doing business. In addition to COGS, this includes fixed-cost expenses such as rent and insurance, variable expenses, such as shipping and freight, payroll and utilities, as well as amortization and depreciation of assets. All the expenses that are necessary to keep the business running must be included.
Operating Profit = Gross Profit - Operating Expenses - Depreciation and Amortization
However, like gross profit, operating profit does not account for the cost of interest payments on debts, tax expense, or additional income from investments. Operating profit reflects the profitability of a company's operations.
Operating profit is also referred to as earnings before interest and tax (EBIT). However, EBIT can include non-operating revenue, which is not included in operating profit. If a company doesn't have non-operating revenue, EBIT and operating profit will be the same figure.
Net income reflects the total residual income that remains after accounting for all cash flows, both positive and negative. In other words, from revenue, which is called the top-line number, all income, expenses, and costs are deducted to arrive at net income.
From the operating profit figure, debt expenses such as loan interest, taxes, and one-time entries for unusual expenses such as lawsuits or equipment purchases are all subtracted. All additional income from secondary operations or investments and one-time payments for things such as the sale of assets are added.
Net income is arguably the most important financial metric, reflecting a company's ability to generate profit for owners and shareholders alike.
Example of Gross and Operating Profit and Net Income
Below is a sample income statement to illustrate the differences and locations of the three profitability metrics.
Gross profit (labeled as gross income) was $3 million for the quarter (or revenue of $5 million minus $2 million in COGS).
Operating profit was $2.2 million for the period, which is calculated by taking gross profit of $3 million minus operating expenses of $1 million (labeled total expenses). However, we must add back in the interest expense of $200,000 because operating profit doesn't include interest (or $3 million - $1 million + $200,000 = $2.2 million).
Net income was $1.5 million for the period, which is located at the bottom of the income statement.