The very reason why you carry out business is to generate profits. These profits indicate the efficiency of your business. This means higher the amount of profit earned during an accounting period, higher is its efficiency.

The term profit is an absolute figure. It represents excess of net revenues over expenses incurred during an accounting period of a business.

Incomes are the earnings generated through business operations conducted on day-to-day basis. Whereas, expenses refer to the cost of resources utilized to manufacture products or render services to the customers.

For instance, consider a garment manufacturing firm selling finished garments during the normal course of business. Now, the firm incurs costs to manufacture garments. Such costs include cost of thread, cloth, wages of labor, heating and lighting charges etc. Now, these expenses form a part of the cost of goods sold. Further, the firm sells the finished garments once they are ready. As a result of selling such garments, the firm earns income.

Now, let’s see how Profit appears in the income statement to know the difference between gross profit and net profit.

Gross And Net Profit in Income Statement

Now, an income statement showcases the incomes earned and expenses incurred during an accounting period. The first level of profit revealed in an income statement is Gross Profit. It is the excess of net sales or revenue over the cost of goods sold incurred by your business.

The next level of profit showcased in an income statement is the operating profit. Operating Profit refers to the profit earned through the normal operations and activities of your business. It is the excess of operating revenue over operating expenses.

Finally, the last level of profit in an income statement, also termed as the bottom line, is the net profit. It is the profit that remains after deducting all operating expenses, non-operating expenses, taxes and preferred stock dividends of a business.

Therefore, every business should earn sufficient amount of profits in order to sustain business and grow in the long run. Thus, we can say that profit is the yardstick to evaluate your business’ economic as well managerial efficiency.

Gross Vs Net Profit

Gross Profit is an item in Trading Account of your company. It is deduced after subtracting the sum of purchases and direct expenses from sales. This means that Gross Profit is the difference between net sales revenue and cost of sales. Cost of sales includes expenses directly related with manufacturing goods or rendering services. These expenses relate with manufacturing, purchase of goods and activities that help in bringing goods to the point of sale. Such expenses include raw material cost, carriage inwards, wages, freight inwards etc. Thus, Gross Profit demonstrates the efficiency of the business in making use of its labor, raw material and other supplies.

On the other hand, Net Profit is an important measure to determine a company’s profitability. It is usually referred to as ‘the bottom line’ of the income statement. Therefore, Net Profit is the difference between Gross Profit and sum of operating and non-operating expenses, taxes and preferred stock dividends. It is one of the components of your business’ profit and loss account. Now, the Net Profit helps both the internal and external stakeholders in making various decisions regarding your business. It helps internal stakeholders like top management to take managerial decisions. Whereas, it makes external stakeholders like investors and creditors aware about the earning capability of your business

Gross Profit Formula and Net Profit Formula

As mentioned above, Gross Profit is the excess of sales over cost of sales. That it is the difference between total sales and the cost of goods sold. Therefore , the formula for Gross Profit is:

Gross Profit = Net Sales – Cost of Goods Sold

or

Gross Profit = Net Sales – (Purchases + Direct Expenses)

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Where cost of goods sold is refer to the direct costs that are incurred to produce goods or render services with the purpose of selling them. Such cost includes the cost of materials and direct labor costs incurred in producing goods.

On the other hand, the formula for Net Profit is as under:

Net Profit = Gross Profit + Other Incomes – Indirect Expenses

Or

Net Profit = Gross Profit – Operating Expenses + Operating Incomes – Non-Operating Expenses + Non-Operating Incomes – Taxes

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Here, the expenses and incomes that are operating in nature relate to the activities performed in the normal course of business. The operating expenses include selling and marketing expenses and general & administrative expenses that help in running the normal operations of business. The operating incomes refer to the ones that are earned as a part of the ordinary course of business. For instance, foreign exchange gains earned by the business as a consequence of exporting goods outside India is an operating income of a business.

On the contrary, the income or expenses that are non-operating in nature are the ones that are not earned or incurred in the ordinary course of business. That is, such activities are not directly related with the normal operations of a business. The expenses that are non-operating in nature include finance expenses like interest. Similarly, non-operating incomes include interest earned on loans or dividends received on securities.

Gross Profit and Net Profit in Income Statement

Gross Profit and Net Profit are the components that appear on the income statement of your business. Therefore, it is important to understand how both the components appear on an income statement. Let’s try to understand this with the help of an example. We will consider the consolidated income statement of Wipro Limited as of March 31, 2018.

As we can see, the first level of profit is the Gross Profit. It stands at Rs 159,296 million for March 31, 2018. This figure is the difference between net sales and cost of sales.

Next, the income statement of Wipro reveals operating profit which amounts to Rs 84,294 million. Note that the operating profit is the difference between Gross Profit and indirect expenses. The indirect expenses are the ones that are associated with two or more cost projects jointly. Such expenses cannot be traced directly to each of the cost projects. Hence, the indirect expenses in case of Wipro include selling and marketing expenses; Rs 42,349 million and general & administrative expenses; Rs 34,141. Whereas the indirect incomes include foreign exchange gains and other operating income. Thus, the operating income for March 31, 2018 amounted to Rs 84,294 million.

Lastly, the net profit is the difference between operating income and non-operating expenses, taxes and non-operating income. Wipro’s non-operating expenses include finance expenses amounting to Rs 5,830 million. While non-operating incomes included Finance and Other Income; Rs 23,999 million and share of profit of equity accounted investee; Rs 11 million. The income tax for the year ended March 31, 2018 stood at Rs 22,390 million. Therefore, the Net Profit (Profit for the year) for Wipro on a consolidated basis amounted to Rs 80,084 million.

Calculation of Profitability Using Gross Profit and Net Profit

Every business examines the profitability of its investments in order to measure and analyze the profit.

Profitability refers to the ability of a business to earn profit from all its activities. It indicates the efficiency with which a business utilizes its resources in order to generate earnings.

Now, the word profitability is further bifurcated into profit and ability. The Profit of a business represents an absolute figure. This standalone figure does not give a fair idea about the sufficiency or change in performance of the business. Whereas, the word ability represents the capability or power of a business to earn profits.

Thus, profitability measures the overall efficiency of a business. Therefore, the optimal way to evaluate business efficiency is to calculate the ratio of input to output. And then compare these ratios either across industry or over different time periods.

Hence, there are certain Profitability ratios that help in evaluating business efficiency:

Gross Profit ratio

Gross profit ratio showcases the relationship between Gross Profit and Net Revenue of your business. It indicates the amount of profit that is available to cover operating and non-operating expenses of your business.

Gross Profit Ratio = (Gross Profit/Net Revenue of Operations) × 100

Net Profit ratio

Gross profit ratio showcases the relationship between Gross Profit and Net Revenue of your business. It indicates the amount of profit that is available to cover operating and non-operating expenses of your business.

Net Profit Ratio = Net profit/Revenue from Operations × 100

Gross Profit Margin

Gross profit margin is a ratio that shows the relationship between a company’s gross profit and its net revenue. It is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets as compared to the sales it generates.

Gross Profit Margin = Gross Profit/Net Sales (Revenues)

Net Profit Margin

Net profit margin is the amount of profit realized by your organization as a percentage of the total sales generated during an accounting period. The objective of calculating such a ratio is to figure out the earning trends of your business over a period of time.

Net Profit Margin = Net Income/Net Sales (Revenue)

Relevance of Gross Profit and Net Profit

Both Gross Profit and Net Profit give important information about the performance of business. Gross Profit indicates efficiency with which a business makes use of its labor, raw material and other supplies. It determines the adequacy of profits to cover operating and non-operating expenses of a business. Therefore, a business needs to compare Gross Profit with net revenue in order to get useful information. For example, a high ratio of gross profit to revenue is a good sign. This indicates that either:

• the operating cost is relatively low; or
• there is an increase in revenue income but operating cost remains constant; or
• there is a decline in operating cost but the revenue income remains the same.

On the contrary, a low ratio of gross profit to revenue is certainly a bad sign. It indicates that either

• the profit is relatively low;
• operating cost is relatively high or
• the revenue income is low.

On the other hand, Net profit is important for the stakeholders. This is because each of them examines it from a different perspective. For instance, the owners of the business analyze its profitability to measure their return on investment. The top management analyzes the profits to measure the efficiency of the business and hence guide the management on its operational aspects. Similarly, the creditors analyze profits to know whether their investment is a safe investment or not.

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