What is Gross vs Net?
Gross pay is what employees earn before taxes, benefits and other payroll deductions are withheld from their wages. The amount remaining after all withholdings are accounted for is net pay or take-home pay.
The concepts of gross and net income have different meanings, depending on whether a business or a wage earner is being discussed. For a company, gross income equates to gross margin, which is sales minus the cost of goods sold. Thus, gross income is the amount that a business earns from the sale of goods or services, before selling, administrative, tax, and other expenses have been deducted.
For a company, net income is the residual amount of earnings after all expenses have been deducted from sales. In short, gross income is an intermediate earnings figure before all expenses are included, and net income is the final amount of profit or loss after all expenses are included. For example, a business has sales of $1,000,000, cost of goods sold of $600,000, and selling expenses of $250,000. Its gross income is $400,000 and its net income is $150,000.
The main flaw in the use of gross and net income for a business is that the gross income figure is more likely to be closely related to the results of operations, while net income can include a variety of non-operational expenses, gains, and/or losses. Thus, the two calculations are based on different sets of information, and are used in different types of analysis.
1. Gross Profit
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 revenue or net sales from a company’s cost of goods sold as shown below:
Gross profit= Net sales-COGES
2. Net Income
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
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.