In examining a business's profitability, there are two key metrics which you need to look at gross profit and net income. Gross profit is total revenue minus the cost of production. So in trying to establish exactly how much a company has made as a result of the sale of its products, investors would look at the gross profit to get a general idea. Net income on the other hand is the money that is left after all applicable expenses have been deducted. This can also tell investors quite a bit about how profitable a company is in general. In this article, we take a look at the differences between gross profit and net income and why these are important to understand.
Gross Profit Basics
To understand where and in what way these different metrics come into play, it may be helpful to think about them in terms of the various phases of production and profit of a company. With gross profit, this number reflects the amount of revenue left over after subtracting the cost of goods sold (COGS/). With this particular number, investors can see, for instance, how efficiently a business is managing overall production costs—everything from labor to raw materials.
To better understand how we arrive at gross profit, it's important to grasp the concept of revenue as well as COGS. Revenue is a pretty straightforward number. Within a given quarter or year, revenue would be the amount of income that a company brings in. When talking about net income, this revenue can come from sources other than just the sale of goods. So for example, if a business has investments and they are making interest on those investments, this would also be counted as revenue.
The cost of goods sold specifically means the money spent on producing and selling the actual products. Under the umbrella term, COGS would fall such expenses as material cost, labor costs, utilities used during production, shipping costs, and equipment costs, among other expenses. The COGS related costs are generally considered to be variable costs for the most part. In other words, these expenses can vary depending on the output. You would not subtract fixed and/or long term costs to arrive at gross profit. Such fixed costs might be rent, insurances, and corporate salaries.
Net Income Basics
Net income is the company's actual profit for a given reporting period. Beyond subtracting strictly the cost of goods sold to arrive at a company's net income you would subtract all expenses from the total revenue. Net income is sometimes referred to as the bottom line given its position on the income statement.
Among the expenses subtracted from total revenue to get to net income are things such as operating expenses, any interest paid regarding debts, overhead expenses, income taxes as well as the depreciation of equipment and other such assets.
Main Differences Between Gross Profit and Net Income
In differentiating between the two among the key differences are what they each reveal about a company's financial picture. For example, gross profit goes toward demonstrating how well a business manages production and labor costs about the amount it is bringing in from its sales. By looking at sales numbers concerning COGS, we can see why in part profits may be increasing or by the same token decreasing. Let's say that a company shows an increase in revenue, and yet, production costs have skyrocketed, the gross profit will decrease. This ultimately does say quite a lot about how the business is managing production overall. And this could consequently be a red flag.
Net income, on the other hand, includes all aspects of a business's operations and the resulting number can therefore provide insight not only into production efficiency but also how well the management team is doing overall. If, for example, gross profit is up but net income drops, this could be an indicator that the company is taking on too much debt or potentially mishandling finances in some other capacity thereby lowering their overall net income despite robust production/sales numbers.
Keep in mind too, that looking exclusively at one or the other can have its limitations. For example, if you take gross profit, there are certain business types and industries that wouldn't find this metric useful. If a company is primarily service-based, they obviously would not have production costs. The gross profit amount would thus not be a helpful measure in that instance. And with net income as well there can be certain limitations. If a business happens to sell off a large asset during a particular reporting period, this would be counted as income. However, the net income for that period might be misleading, as the business's profitability for that reporting period is not necessarily attributable to product sales but rather a one-off asset sale. This is why both numbers are needed to paint a truly authentic picture of a business's financial health.
Other Useful Metrics
While gross profit and net income are certainly two of the more important numbers that businesses need to be aware of and consequently track, other figures factor into understanding how a company is positioned financially. There is an operating profit to consider for example—this is basically the company's profit before interest and taxes are taken out; it is also referred to as EBIT (earnings before interest and taxes/). Additionally, there is the accounts receivable turnover ratio which shows how well you collect the cash from credit sales. There are several financial metrics which companies need to keep an eye on and which can ultimately help them make key decisions moving forward.
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