REFRESHER: GROSS PROFIT VS. NET PROFIT
A few more basic terms to refresh our financial analysis foundation of knowledge:
- Gross Profit
- Net Profit
- Cost of Goods Sold
Gross Profit (sometimes referred to as Total Profit) is found by taking the total received for a product or service and subtracting the Cost of Goods Sold (COGS). This does not include most of the operating/working expenses and fixed costs such as rent, insurance, and taxes.
The Cost of Goods Sold (COGS) are the direct costs found in the production of a product or service. This includes direct labor costs.
Net Profit (sometimes referred to as the Bottom Line, Net Income, and Net Earnings) is the actual profit found when you take the Gross Profit and subtract all the operating/working expenses.
A common pitfall with business owners and managers is believing that if the Gross Profit is strong then their business will be successful. This is common in retail business where they plan to buy a product for $5 and then resell it for $10. At first, this sounds like a “can’t lose” situation, right? This is where the Net Profit is useful.
If you look at the Net Profit in the example above it may show something different. If the operating/working expenses and fixed costs such as rent, insurance, and taxes are high the $5 Gross Profit can still result in a Net Profit of $0 very quickly and could even be negative.
So, it is important that both Gross Profit and Net Profit are determined. It can show what needs to happen to make the business truly successful at the bottom line and decisions can then be made properly to maximize both Gross and Net Profit. On-going monitoring and comparing of year-to-year results will assist the business owner with moving forward in the best way possible.