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 determine how much profit a company earns from producing and selling its goods and services. Gross profit is sometimes referred to as gross income.
Net income is the profit that remains after all expenses and costs have been subtracted from revenue. Net income—also called net profit—helps investors determine a company's overall profitability, which reflects 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 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 as the "bottom line."
Contrasting Gross Profit And Net Income
Gross profit, operating profit, and net income refer to a company's earnings. 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 efficiently a company manages 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 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 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, some fixed costs are salaries (but not wages), rent, utilities, 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, 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:
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 incurs, which are subtracted from revenue. Net income is often called "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. In contrast, a company in the service industry would not have COGS—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
Assume 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).
Gross profit assesses a company's ability to earn a profit while 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 didn't hire enough 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 the other costs involved in running the company.
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 borrowing too much. The additional interest expense for servicing more debt could reduce net income despite the company's successful sales and production efforts.
Limitations of Gross Profit and Net Income
Gross profit is not a very useful metric on its own. Net income is far more helpful in determining the financial position of a business. But even net income is limited in that it is only useful for evaluating one company's performance from year to year.
Comparing the net incomes of two different businesses doesn't tell you much either, even if they are in the same industry. It merely tells you which one generated more income according to how that company accounts for its expenses.
Net income can be misleading—non-cash expenses are not included in its calculation. When these are subtracted, net income can be drastically reduced.
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 earnings before interest and taxes (EBIT).
However, when calculating operating profit, the company's operating expenses are subtracted from gross profit. Operating expenses include overhead costs, such as salaries, licensing costs, or administrative activities. 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. These can wipe out gross profit and lead to a net loss (or negative net income).
Users of Gross Profit vs. Net Income
In many cases, the primary difference between gross profit and net income is the different user bases and their intentions with the information.
Business owners and managers use gross profit information to assess the profitability of their core business operations. Though business owners use net income, select department leads will be more specifically interested in how the actual product manufacturing and sales perform without considering administrative costs.
Net income is an important metric that investors use to assess a company's profitability and growth potential. If a company does not have a positive net income, investors may not be interested. Even if a company has positive gross profit, investors are primarily interested in knowing what net income will be generated and what potential future dividend distributions (from net income, not gross profit) may be returned to them.
Lenders and Banks
Lenders and financial institutions use net income information to assess a company's creditworthiness and to make lending decisions. As a result, banks often require a company to provide an income statement (and often a multi-year income statement) before issuing credit. Though the bank may underwrite based on the gross profit of primary product lines, banks are most interested in seeing net cash flow after all expenses (especially interest).
Governments don't charge taxes on gross profit. Federal, state, and local taxes are often assessed after all expenses have been considered. Though certain tax credits or deductions may closely relate to gross profit, government entities are more interested in a company's net income when assessing tax.
Gross Profit vs. Net Income Examples
In most cases, companies report gross profit and net income as part of their externally published financial statements. Consider the image below, which shows Best Buy's income statement for the fiscal years ending in 2020, 2021, and 2022.
For fiscal year 2022, the company reported $51.7 billion in net sales and had a cost of goods sold (cost of sales) of $40.1 billion. Therefore, as specified in its financial statements, the company had a gross profit of $11.64 billion.
Looking further down the financial statements, you'll notice that's a far cry from the $2.4 billion of net income the company reports. Though most of this difference is due to selling, general, and administrative (SG&A) expenses, Best Buy also paid $574 million of income tax.
In a different example, Macy's reported all components needed as part of the Q-3 2022 reporting for the period ending October 29, 2022. However, the company's consolidated statement of income does not explicitly state gross profit. Analysts must calculate that on their own which will be the difference in total sales ($5.23 billion + 0.2 billion) and the cost of goods sold ($3.2 billion).
As seen before with Best Buy, Macy's gross profit of over $2.2 billion dramatically differs from its net income. Due to SG&A costs, settlement charges, interest expenses, impairment and restructuring costs, and income taxes, Macy's net income for the period was just $108 million.
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 into how effectively a company generates profit from its production process and sales initiatives.
What Is Net Income?
Net income represents a company's overall profitability after all expenses and costs have been deducted from total revenue. Net income also includes any other types of income that a company earns, such as interest income from investments or income received from the sale of an asset.
Is Net Income or Gross Income Higher?
Gross income will almost always be higher 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 and other income and revenue sources that are not included in gross income. Some costs subtracted from gross profit 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 a company's final measure of profitability. Net income is also called net profit since it represents the net 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 deducting production costs. Gross profit helps to show how efficient a company is at generating profit from producing its goods and services.
Net income, on the other hand, represents the income or profit remaining after all expenses have been subtracted from revenue. It also includes other income sources, such as income from the sale of an asset. Both gross and net income are important but show a company's profitability at different stages.
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.