Why the Difference Between Net Profit vs. Gross Profit is Important for your BusinessWant to know how to calculate your monthly net income? This article explains net vs. gross profit (+ strategies to boost your bottom line).
A few years after starting a new business, you’ve learned a lot. The processes involved in owning your own company are constantly evolving and changing, so there is always more to learn. One essential is knowing the jargon, but it can be a struggle to find the time to teach yourself the terminology, especially in the area of accounting.
One of the best parts of owning your own business is that you don’t need a particular education to be successful. But anytime you’re dealing with money, taxes, and payroll, it pays to learn the rules. Lack of knowledge and training isn’t a valid excuse if you make mistakes.
A financial topic that confuses a lot of business owners is net profit versus gross profit.
In fact, these terms muddle the minds of millions of people, even those who work as employees. The question, “What’s your monthly net income?” can trigger fear in the hearts of some of the most brilliant brains!
So if these terms are also confusing to you — it’s normal!
If you’ve ever questioned the correct way to calculate your monthly net income or wondered about the types of profits, this article is for you. It explains everything you need to know about net vs. gross profit and gives you some strategies to boost your bottom line.
1. All About Your Gross Profit
For a product or service to be worth the effort it takes to produce it, you have to have some sort of gross profit. This profit can be neutral if your company is a non-profit. But it can’t cost you money to do the work, or you will eventually run out of funds.
A business’s gross profit, also called “gross income,” only pays attention to the amount of money coming in and the costs it took to make and sell its wares.
For instance, if you design a product that costs ten dollars for materials and twenty dollars for labor, but you sell it for fifteen dollars, you have a negative profit. It costs you fifteen dollars to create and sell that product. At some point, this is going to put you out of business.
The gross income isn’t the only part of your company that determines your success. It’s essential when you’re trying to figure out how efficient your processes are.
Using Your Gross Profit Statistics
Your company’s gross profit is a strong measure of the performance of your business. It shows you how well you’re making use of the materials you have, your labor, and the supplies.
The gross profit formula looks like this:
Gross Profit = Revenue − Cost of Goods Sold
The gross profit is what shows up on the company’s income statement. Since the revenue and cost of goods sold (COGS) can vary throughout the year, keeping tabs on your gross profit is crucial.
Your business isn’t the only one out for a profit. As the cost of direct labor and raw materials increases, your suppliers are going to charge you more.
Implementing procedures that regularly check your company’s gross income helps you catch small changes and use them to adjust your own policies.
Unfortunately, many businesses neglect this piece of their accounting picture. Until they realize their company isn’t making the profits it should, they don’t notice a problem.
2. What Your Net Profit Means
When a business is successful, it’s because its net profit figures are “in the black.” Your company’s net profit, also called a net income, is how much money you have in the bank after paying your total expenses.
Also called “net income,” this is your overall profit. It’s what the lenders usually look at when deciding if you qualify for a loan or credit card. When you evaluate your financial statements, the net profit is what you’re looking for.
Calculate net profits by subtracting your operating expenses from your revenue. This is the final answer that lets you know if your business is bringing in money or not.
The formula to determine your business’s net profit is:
Total Revenue – Total Business Expenses = Net Profit
One important thing to note:
Net profit does not include your income tax payments. These are determined after your net income calculations because they’re a percentage of your profit.
Using Your Net Profit Knowledge
We all want to know how much money we’re earning.
As a business owner, though, this is important on a grander scale. If you’re not making enough to cover your overhead and expenses, something needs to change.
Some companies use their revenue to determine the success of their business. But if the revenue isn’t enough to cover their expenses, it doesn’t matter how much they are bringing in.
If there’s no profit, the business is not likely to succeed long-term.
Business owners also use the net profit to determine factors such as:
- The total cost of running the business
- The net sales of a specific product
- The company’s operating profit
- What profit is available to invest back into the company for growth
- The company’s overall financial health
- The potential likelihood of obtaining a loan through a bank or other creditor
All of these factors are important pieces of the entire puzzle that determine the future of a business.
Using Net Profit to Predict Your Success
For any business to be successful in the long run, the net profit should be predictable month-to-month.
Patterns are the key to this. Your busier seasons, like the holidays, can make up for your “drier” months if you prepare. Eventually, the goal is to have a consistent net profit that you can use to cover your expenses regularly.
Take a business that relies on tourism, for example, like restaurants in central Florida. The “busy season” there is around October through March when the state is full of older northerners getting away from the harsh winter months. In the spring, they head back up to their home states.
As a restaurant owner in that area, you’d watch for patterns in the economy around you and use those patterns to plan your budget. During the busy season, your net profit should include putting aside money for expenses while the economy is slower.
This, of course, relies on your business having enough of a profit to cover your current overhead and set some aside for the slower months. That’s not always the case.
3. Boosting Your Revenue to Increase Net Profit
Your net margin (net profit margin) is where you get the funds to do the surplus things. Maybe you’d like to invest back in your company to help it grow, give your staff bonuses, or take a vacation.
If you’re barely making ends meet, these extras aren’t possible. But there are a few things you can do to increase your net profit and get out of the “just skating by” zone or grow your company.
Of course, the first suggestion is always to raise your prices. It’s the “easiest” thing to do, but it does have some drawbacks.
Before you ask for a higher cost for your product or service, do your research.
How much is your main competition charging? Will your customers stay with you or go elsewhere if they can get something similar for less?
If you do decide to raise your prices, make small increases, paying attention to the market. When people are nervous to spend, the demand for everything is going to decrease. Raising your price at that point is likely to backfire.
Besides raising your prices, you can use your website to target your customers with discounts. People are more likely to shop at a business if they feel like they’re getting a bargain.
You can automate email campaigns to let your customers know if you’ve had a change they need to know about. A rewards program is another way of using your email list to increase your sales revenue.
Be cautious when you offer discounts, though. You still need to make a profit. Your marketing strategy should consider your gross profit and how much you need to make a net profit.
4. Cutting Costs to Increase Your Profit
Another strategy to increase your net profit is to cut your expenses. You hear about this frequently with major corporations laying off employees, but you don’t have to go to that extreme right away.
First, use your gross and net profit formulas to figure out if you have inventory and services that aren’t selling or profitable. See if you can remove them from your offerings without losing clients.
For instance, say you are part of a supply chain that delivers chicken wings to a grocery store. The demand for wings shoots up, and your supplier raises their price. When you work out your gross profit, you realize you’re not making enough to cover your basic costs with what you’re currently charging.
Do you cut chicken wings off your inventory completely and potentially lose most of your customers, like this grocery store? Or do you slowly increase your prices, keeping an eye on sales while you do so?
In that case, you’d increase your prices because you need the inventory to attract customers. But there are other things you can cut instead of chicken wings – like offering a loss leader that gets them to buy more wings at a higher price.
Related: How Much Inventory Is Too Much?
Cutting Costs the Simple Way
You don’t need to be part of a food supply chain to understand the concept of raising prices versus cutting costs in your business operations. You’ll have to decide if it makes more sense to do one or the other in each instance.
When you have to cut back, try lowering your overhead costs if possible. In a business where a brick-and-mortar shop isn’t necessary, this could be as simple as moving to online only.
If you have employees doing a job, you have to pay administrative expenses, payroll taxes, and give them benefits. Switching to hiring freelancers or independent contractors takes away these extra expenses.
Talk to your suppliers to see if you can negotiate better rates or move your business elsewhere. This includes your phone, credit card system, insurance, and other variable rate services.
But when your net profit is down, and it’s a temporary issue, you might not want to make a permanent change. You may be waiting for a few big clients to pay their invoices. In the meantime, you need some working capital to cover your expenses.
When your business relies on invoicing, you can cut costs by moving to an accelerated invoicing system instead of waiting for clients to pay.
That’s where NowAccount can help you. This invoice acceleration solution steps in where traditional bank loans aren’t necessary. You deliver the goods or services, and NowAccount pays you immediately. Since they collect from the client, your customers can keep the longer payment terms they prefer and pay through NowAccount later.
This system helps you cut costs by paying you within one day, so you have the cash flow to cover your overhead. You don’t have to get stuck with late fees and extra interest rates on your bills because your clients delayed paying you.
5. Improving Your Net Profit With Marketing
Marketing is a meaningful way to improve your net profit. Every business that wants to grow needs a marketing strategy to reach its goals.
With so many companies going digital, it’s easy to use a platform like Shopify to monitor your e-commerce metrics. You do your thing, and it collects your metrics in the background. When you run the reports, you can look for the products that are selling well and those that are not profitable.
Taking out Google and social media ads is another piece of a successful marketing strategy.
Find an ad company that targets your ideal customer, like Google or Facebook. That way, your advertising pays for itself with more sales generated. You can monitor your metrics here, too, to ensure your strategy is working.
It’s also a good idea to learn the basics of search engine optimization (SEO). When you maximize your SEO, you can end up on the first page of a user’s search engine results — the gold standard of a business’s marketing campaign.
Whether you have an online company or you’re a growing business, success is the bottom line.
Your net and gross profit numbers will help you as you adjust your expenses and costs to maximize profitability.
Set up your NowAccount to see if you qualify for accelerated invoice payments.