Gross profit, net profit & profit margins

What’s gross profit?

Gross profit is the amount of money you earn in sales, minus the cost of producing your goods or services.

So if you were a baked bean manufacturer, your cost of goods would include:

• Ingredients

• Cans and labels

• The wages of the people who work on the production line

Cost of goods wouldn’t include:

• Marketing and advertising spend

• The wages of staff not involved in the production line, like those in HR or finance

You can talk about gross profit at a company level – for example, the baked bean company made £2,080 gross profit this year. Or a unit level – for example, the baked bean company made £0.40 gross profit per can.

What does gross profit tell you?

Gross profit is a really important business metric, as it tells you whether your business is profitable or not at its most basic production level.

If production or service costs exceed sales prices, your business won’t work out. So it’s important you can sell your product at a high enough price to cover these costs.

If your gross profit is low or negative, you’ll want to find ways to increase your gross profit by doing things like:

• Paying less for your materials

• Producing more products in the same amount of time or with same amount of staff by increasing production efficiency

• Charging more for your product

And remember, you’ll have additional expenses beyond production, like office space, equipment and marketing. Your sales income will also need to cover these costs for your business to be profitable – more on that when we cover net profit.

Gross profit versus gross profit margin

Gross profit and gross profit margin both measure a company’s profitability. Gross profit is displayed in pounds and pence (or your local currency), while gross profit margin is a ratio or percentage.

So the baked bean company might make £0.40 gross profit per can, but their gross profit can also be expressed as a margin, e.g. 66%.

How to calculate gross profit and gross profit margin

To calculate gross profit:

• Add up all of the costs involved in providing your product or service

• Subtract the cost from the amount you sell your product for

• The number that’s left is your gross profit

For example, if it costs you £0.20 to make a can of beans and you sell the beans for £0.60 a can, your gross profit is £0.40 a can.

If you’re currently selling 100 cans a week, or 5,200 per year, your annual gross profit would be: £3,120 revenue - £1,040 costs = £2,080 annual gross profit.

To calculate gross profit margin, subtract the cost of goods from the selling price, then divide that number by the selling price, and multiply by 100%. Here’s an example using the beans: £0.60 - £0.20 = £0.40 £0.40 ÷ £0.60 x 100% = 66.66%

What’s a good gross profit margin?

It really depends on the industry, specifically how many products you expect to sell and what the profit margin is.

A low profit margin is okay if you sell a high volume of products, for example a wholesaler.

And a low volume of sales is okay if you sell a high margin product, for example supercars.

But you’ll want to avoid selling products with both low volume and low profit margins

The age of the business is another important factor – new businesses might have a lower profit margin than more established ones for reasons like:

• Lower initial rates to attract clients, or because they have less experience

• Less established relationships with suppliers, which could mean more expensive materials

• The scale of operations – buying ingredients in bulk generally means you can get a better deal than buying small quantities

The Office of National Statistics has data on rates of return by industry, which will give you an idea of what a good profit margin would look like for your industry.

What’s net profit?

Net profit, or net income as it’s sometimes called, is similar to gross profit in that it’s a measure of business efficiency and profitability – but it’s calculated differently.

Gross profit only takes into account the cost of goods, while net profit considers all business costs. These might include marketing and advertising spend, non-production departments like marketing or HR, and office space.

What does net profit tell you?

Net profit tells you whether your business as a whole is making money.

You could have positive gross profit, but your net profit margin could be low or even negative. This would mean that you’re making enough money to cover the production cost of your product or service, but not enough to support your business as a whole.

Taking steps to improve your gross profit could improve your net profit, but you could also consider doing things like:

• Improving the efficiency of your marketing activity

• Reducing operating costs – for example, finding a cheaper office space

• Spending less on non-production staff costs

Just remember to consider how mature your business is when thinking about net profit. If you’re just starting out you might not be making many sales yet, so you may want to invest more in marketing or offer lower prices while you get established. This might mean your net profit is low or negative for a while, but it’ll hopefully pay off in the long-run. If your business is more mature and still operating with a low or negative net profit, that may mean something needs to change.

Finally, think about your business plan. Some businesses might sell products on a small scale or in a niche industry, so need a higher net profit margin than companies who sell hundreds of thousands of products. They might not make much money per product (low gross profit margin) but they sell so many that their net profit margin is high.

How to calculate net profit

• Add up all of the costs involved in your business

• Subtract this cost from the amount you sell your product for

• The remaining number is your net profit

For example:

• You’re selling 5,200 cans of beans per year at a cost of £0.60 per can

• 5,200 x £0.60 = £3,120 revenue

• The total business costs are £2,080

• This means your net profit is £1,040 for the year (£3,120 - £2,080)

This would make your net profit margin 33.33%: (Net income £1,040 ÷ revenue £3,120) x 100 = 33.33

Gross profit versus net profit

To summarise, gross profit is the money your business makes less the cost of manufacturing the goods or providing the service. And net profit is the amount of money your business makes taking into account all business cost.

This article is for information purposes only and does not constitute legal, tax or accounting advice. You should get professional advice if you need help to understand your legal rights or to manage your accounting or tax affairs.

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