Gross Profit vs. Net Income: An Overview
Two critical profitability metrics for any company include gross profit and net income. Gross profit represents the income or profit remaining after the production costs have been subtracted from revenue. Revenue is the amount of income generated from the sale of a company's goods and services. Gross profit helps investors to determine how much profit a company earns from the production and sale of its goods and services. Gross profit is sometimes referred to as gross income.
On the other hand, net income is the profit that remains after all expenses and costs have been subtracted from revenue. Net income or net profit helps investors determine a company's overall profitability, which reflects on how effectively a company has been managed.
Understanding the differences between gross profit vs. net income can help investors determine whether a company is earning a profit, and if not, where the company is losing money.
- Gross profit refers to a company's profits after subtracting the costs of producing and distributing its products.
- Gross profit determines how well a company can earn a profit while managing its production and labor costs.
- Net income indicates a company's profit after all of its expenses have been deducted from revenues.
- Net income is an all-inclusive metric for profitability and provides insight into how well the management team runs all aspects of the business.
- Net income is often referred to simply as the "bottom line."
Contrasting Gross Profit And Net Income
Gross profit, operating profit, and net income refer to the earnings that a company generates. However, each one represents profit at different phases of the production and earnings process.
Gross profit is a company's profits earned after subtracting the costs of producing and selling its products—called the cost of goods sold (COGS). Gross profit provides insight into how efficient a company is at managing its production costs, such as labor and supplies, to produce income from the sale of its goods and services. The gross profit for a company is calculated by subtracting the cost of goods sold for the accounting period from its total revenue.
Revenue is the total amount of money earned from sales for a particular period, such as one quarter. Revenue is sometimes listed as net sales because it may include discounts and deductions from returned or damaged merchandise. For example, companies in the retail industry often report net sales as their revenue figure. The merchandise that has been returned by their customers is subtracted from total revenue. Revenue is often referred to as the "top line" number since it is situated at the top of the income statement.
Cost of Goods Sold (COGS)
Cost of goods sold refers to the direct costs involved in producing a company's goods. COGS typically includes the following:
- Direct materials, such as raw materials and inventory
- Direct labor, such as wages for production workers
- Equipment costs used in production
- Repair costs for equipment
- Utilities for production facilities
- Shipping costs
We can see from the COGS items listed above that gross profit mainly includes variable costs—or the costs that fluctuate depending on production output. Typically, gross profit doesn't include fixed costs, which are the costs incurred regardless of the production output. For example, fixed costs might include salaries for the corporate office, rent, and insurance.
However, some companies might assign a portion of their fixed costs used in production and report it based on each unit produced—called absorption costing. For example, let's say a manufacturing plant produced 5,000 automobiles in one quarter, and the company paid $15,000 in rent for the building. Under absorption costing, $3 in costs would be assigned to each automobile produced.
How to Calculate Gross Profit
Gross profit is calculated by subtracting the cost of goods sold from a company's revenue or net sales, as shown below:
Both gross profit and net income are found on the income statement. Gross profit is located in the upper portion beneath revenue and cost of goods sold. Net income is found at the bottom of the income statement since it's the result of all expenses and costs being subtracted from revenue.
Net income is synonymous with a company's profit for the accounting period. In other words, net income includes all of the costs and expenses that a company incurred, which are subtracted from revenue. Net income is often referred to as the bottom line due to its positioning at the bottom of the income statement.
Although many items can be listed on a company's income statement, depending on the company's industry, usually net income is derived by subtracting the following expenses from revenue:
- Operating expenses
- Interest on debt and loans
- Overhead or selling, general, and administrative expense (SG&A)
- Income taxes
- Depreciation, which is the allocation of the costs of fixed assets, such as equipment, over their useful life or life expectancy
Additional income sources are also included in net income. For example, companies often invest their cash in short-term investments, which is considered a form of income. Also, proceeds from the sale of assets are considered income.
How to Calculate Net Income
As stated earlier, net income is the result of subtracting all expenses and costs from revenue, while also adding income from other sources. Depending on the industry, a company could have multiple sources of income besides revenue and various types of expenses. Some of those income sources or costs could be listed as separate line items on the income statement.
For example, a company in the manufacturing industry would likely have COGS listed, while a company in the service industry would not have COGS but instead, their costs might be listed under operating expenses.
The general formula for net income could be expressed as:
- Net Income = Total Revenue — Total Expenses
A more detailed formula could be expressed as:
- Net Income = Gross Profit — Operating Expenses — Other Business Expenses — Taxes — Interest on Debt + Other Income
Net Income Example
Let's say a company generated $1 million in revenue and had the following costs and other income:
- Cost of goods sold of $600,000
- Operating expenses of $200,000
- Debt payments of $10,000
- Tax payments of $5,000
- Interest income of $8,000
Net income would equal $193,000 ($1,000,000 - $600,000 - $200,000 - $10,000 - $5,000 + $8,000).
Investors often hear the phrase: "A company posted top-line or bottom-line growth." Top-line growth means a growth in revenue since revenue is the first or top line of the income statement. Bottom line growth refers to a growth in net income since net income is listed on the bottom line of the income statement.
Gross profit assesses a company's ability to earn a profit while simultaneously managing its production and labor costs. As a result, it is an important metric in determining why a company's profits are increasing or decreasing by looking at sales, production costs, labor costs, and productivity. If a company reports an increase in revenue, but it's more than offset by an increase in production costs, such as labor, the gross profit will be lower for that period.
For example, if a company hired too few production workers for its busy season, it would lead to more overtime pay for its existing workers. The result would be higher labor costs and an erosion of gross profitability. However, using gross profit as an overall profitability metric would be incomplete since it doesn't include all of the other costs involved in running a successful business.
On the other hand, net income represents the profit from all aspects of a company's business operations. As a result, net income is more inclusive than gross profit and can provide insight into the management team's effectiveness.
For example, a company might increase its gross profit while simultaneously mishandling its debt by borrowing too much. The additional interest expense for servicing the debt could lead to a reduction in net income despite the company's successful sales and production efforts.
Limitations of Gross Profit and Net Income
Gross profit can have its limitations since it does not apply to all companies and industries. For example, a services company wouldn't likely have production costs nor costs of goods sold. Although net income is the most complete measurement of a company's profit, it too has limitations and can be misleading. For example, if a company sold a building, the money from the sale of the asset would increase net income for that period. Investors looking only at net income might misinterpret the company's profitability as an increase in the sale of its goods and services.
Operating Profit, Gross Profit, and Net Income
It's important to note that gross profit and net income are just two of the profitability metrics available to determine how well a company is performing. For example, operating profit is a company's profit before interest and taxes are deducted, which is why it's referred to as EBIT or earnings before interest and taxes.
However, when calculating operating profit, the company's operating expenses are subtracted from gross profit. Operating expenses include overhead costs, such as the salaries from the corporate office. Like gross profit, operating profit measures profitability by taking a slice or portion of a company's income statement, while net income includes all components of the income statement.
If gross profit is positive for the quarter, it doesn't necessarily mean a company is profitable. For example, a company could be saddled with too much debt, resulting in high interest expenses, which wipes out the gross profit, leading to a net loss (or negative net income).
Gross Profit vs. Net Income Example
Retail giant J.C. Penney has been one of the many retailers that have experienced financial hardship over the past several years. Below is a comparison of the company's gross profit and net income in 2017, as well as an update from 2020.
J.C. Penney reported the following income statement for 2017 on its 10-K annual statement:
- Revenue and net sales: $12.50 billion
- Gross profit: $4.33 billion or (total revenue of $12.50 billion - COGS of $8.17 billion)
- Net income: $116 million loss
Although J.C. Penney earned $4.33 billion in gross profits that year, after deducting the remaining expenses, including selling, general, and administrative (SG&A) costs, plus the interest cost of its debt, the company actually suffered a $116 million loss. This real-life example demonstrates why it is critical to analyze a company's financial statements using multiple metrics to accurately determine whether the company is performing well or experiencing losses.
J.C. Penney has continued to struggle. In Q3 2020, the company reported $1.758 billion in total revenue and had $1.178 billion in cost of goods sold, which means gross profit was $580 million.
However, the company posted a net loss of $368 million. Although the recession following the coronavirus outbreak in 2020 hurt many retailers, J.C. Penney had reported a net loss of $93 million in the same quarter in 2019.
Although the company has generated revenue and positive gross income, J.C. Penney shows how costs and interest on debt can wipe out gross profit and lead to a net loss or a negative figure for net income.
Companies can report a positive net income and negative gross profit. For example, a company with poor sales and revenue performance might post a gross profit as a loss. However, if the company divested an asset or product line, the cash received from the sale could be enough to offset the loss, resulting in a net profit for the quarter.
What Is Net Income?
Net income represents the overall profitability of a company after all expenses and costs have been deducted from total revenue. Net income also includes any other types of income that a company earned, such as interest income from investments or income received from the sale of an asset.
What Is Gross Income?
Gross income or gross profit represents the revenue remaining after the costs of production have been subtracted from revenue. Gross income provides insight as to how effective a company is at generating profit from its production process and sales initiatives.
Is Net Income or Gross Income Higher?
Gross income will almost always be a higher figure than net income, since gross profit has not accounted for various costs (e.g., taxes) and accounting charges (e.g., depreciation).
How Do I Calculate Net Income From Gross?
Net income is gross profit minus all other expenses and costs as well as any other income and revenue sources that are not included in gross income. Some of the costs subtracted from gross to arrive at net income include interest on debt, taxes, and operating expenses or overhead costs.
Is Net Income the Same as Profit?
Typically, net income is synonymous with profit since it represents the final measure of profitability for a company. Net income is also referred to as net profit since it represents the net amount of profit remaining after all expenses and costs are subtracted from revenue.
The Bottom Line
Gross profit or gross income is a key profitability metric since it shows how much profit remains from revenue after the deduction of production costs. Gross profit helps to show how efficient a company is at generating profit from the production of its goods and services.
Net income, on the other hand, represents the income or profit remaining after all expenses have been subtracted from revenue, while also including any other income sources, such as income from the sale of an asset. Both gross income and net income are important but show the profitability of a company at different stages.
Other profitability metrics are used, as well. For example, net profit margin is calculated by dividing net income by revenue and multiplying the result by 100 to create a percentage. Net profit margin shows the percentage of profit that's been generated from each dollar of revenue. Similarly, gross profit margin is calculated by dividing gross income by revenue and multiplying the result by 100.
Both gross margin and net profit margin are popular profitability metrics used by investors and analysts when comparing the level of profitability between one company to another. The term profit is also used when calculating the return on investment (ROI). ROI represents the profit earned after deducting the original cost from the market value, dividing by the original cost, and multiplying the result by 100.
Although net income is considered the gold standard for profitability, some investors use other measures, such as earnings before interest and taxes (EBIT). EBIT is important because it reflects a company's profitability without the cost of debt or taxes, which would normally be included in net income.
If an investor wants to know if a company is improving its sales and cost controls, EBIT helps to strip away some of the items that management has little control over or that don't reflect the sales and production performance of the company. As with any financial metric, it's best to use a combination of profitability measures to determine the extent of a company's profitability.