Gross profit and net profit are key indicators of the performance of the business, when compared to prior periods, and budgets.
What is Gross Profit?
Gross profit is sales (or turnover) less the direct cost to the business of the goods or services sold in the period. These direct costs will vary depending on the type of business. Taking a manufacturing business as an example, the cost of the raw materials used in the period, and the labour costs directly involved in producing the items for sale would represent the costs of goods sold.
For a service business, such as a maintenance company, costs of goods sold will predominantly be the direct labour costs of the employees carrying out the work, the cost of parts and consumables used, as well as any subcontractor costs, where subcontractors are used instead of internal labour.
What does the Gross Profit tell us?
The level of gross profit, and whether it is increasing or decreasing, indicates how efficiently the business has produced the goods or services sold in the period. Gross profit can move due to a change in sales volume or due to a change in direct costs, and therefore it is important to review both of these elements, when reviewing performance and for future decision making.
For example, a decrease in gross profit margin (gross profit as a percentage of turnover) may indicate that costs have increased faster than sales prices. This data can then be used to make decisions on sales pricing, to re-negotiate terms with suppliers, look to source alternative suppliers, or develop higher margin products.
What is Net Profit?
Net profit is the gross profit less all other expenditure, overheads, and tax charges the business has incurred in the period. Such expenditure includes administrative salaries, overheads such as rent, rates and utility costs, and other costs which are not directly related to the sale of goods, such as professional fees and repair and maintenance costs. These costs are shown in the financial statements as ‘Administrative Expenses’. The net profit line is shown in the financial statements as ‘Profit after tax’, and this is the maximum amount of profit available for distribution to the shareholders as dividends. A positive gross profit figure and a negative net profit suggests either a gross profit level, which is not sufficient to cover all the business overheads, or excessive overhead costs. It is therefore important to review both gross and net profit when reviewing performance.
If you need help with this, or with other advice, then please get in touch with our accounting team.