What is Gross Profit?
Gross profit is the amount you make after deducting the cost of your revenue, also known as the Cost of Goods Sold (COGS). The cost of your raw materials and any other expenses directly related to production are part of COGS and SaaS cost of revenue.
However, the COGS and SaaS cost of revenue exclude overhead costs, like rent, utilities, and other administrative expenses. It also excludes marketing expenses.
Determining Which Expenses to Include in Your COGS
To determine which expenses to add to your Cost of Goods Sold, you need to ask yourself a simple question. Ask yourself if you would still incur that expense if you stopped selling the products in the future.
If the answer is yes, you should not add the expenses to your Cost of Goods Sold. In other words, it is not a cost of revenue.
Calculating Gross Profit
The gross profit, also referred to as gross income, is calculated as the difference between sales revenue (or net sales) and the Cost of Goods Sold (COGS).
Sales revenue for a Software as a Service (SaaS) company usually includes earnings from subscription fees and other add-on features. It excludes income derived from outside investments or non-business activities, such as the sale of an asset.
Gross Profit = Net Sales - Cost of Goods Sold (COGS)
For example, you have $200,000 as the Net sales of your company. Then, you have $150,000 as your cost of goods sold (COGS). Applying the gross profit formula (Net sales – COGS), your gross profit would be ($200,000 - $150,000) =$50,000.
Note: Administrative costs and operating expenses, such as rent or insurance, are not included in this gross profit calculation.
Furthermore, costs related to goods and services are part of the Cost of Goods Sold. For instance, if you only sell digital goods and services, your COGS will include expenses for:
- Hosting applications
- Software licenses and subscriptions
- Cloud storage and Servers
For businesses that sell tangible (physical) products, COGS will include the cost of raw materials, labor, production, and other expenses to subtract from business revenue. Interests, taxes, and overhead expenses should not be part of it when you are calculating a gross profit.
What Gross Profit Tell you About Your Company
Gross profit is a parameter that provides vital insight into your company's financial health. Using your gross profit, you can calculate your gross profit margin (which compares your Gross Profit to your revenue). In turn, you can use the gross profit margin to compare the operations of your product-related businesses to those in the market and comparable companies.
For instance, according to the New York University (NYU) Stern School of Business, SaaS companies usually operate with high Gross Profit margins between 60 and 70 percent. It means you might need to find ways to cut your product-related costs if your SaaS business runs at a gross profit margin below 40 percent. However, you might face a loss at first if you are starting up and have a high upfront cost.
For instance, a limited dataset from HubSpot, Salesforce, and Asana revealed that 83 percent of SaaS businesses lost money when they went public. Although a SaaS company may not make a profit overall, a positive gross profit is a vital early indicator many investors will consider. It is comparable to the Rule of 40. The Rule of 40 states that the combined profit margin and growth rate of a healthy SaaS company should both be at least 40 percent.
Also known as net income, net profit calculates your business's actual profit versus revenue after considering both positive and negative cash flows. Furthermore, since net profit is the last line on your income statement, it is also known as your business bottom line.Positive Versus Negative Cash Flows
Positive cash flows consist of sales revenue. In addition to your sales revenue, positive cash flows also come from additional income sources like investments or money made from the sale of an asset.
On the other hand, negative cash flows are all your expenses, including the cost of goods sold, taxes, loan interest, and one-time fees or payments.
How to Calculate Net Profit
Net profit is the difference between total revenue (or top line) and total expenses. In the net profit calculation, total revenue is the starting point, then add all positive cash flow amounts and deduct every negative cash flow amount.
Total revenue in this context refers to all sources of revenue. Thus, you should include both your sales revenue and your investment income. Similar to total expenses, total expenses cover all the company expenses, including administrative and product-related costs.
Net Profit = Total Revenue - Total Expenses
For example, your company has a gross profit (total revenue) of $50,000 plus expenses and taxes of $10,000. Using the net profit formula (total revenue - total expenses), your Net profit would be ($50,000 – $10,000) = $40,000
What Gross Profit Tells you About your Company
Net profit is another parameter that provides a vital insight into your company's financial health. Your company's net profit also lets you know whether you have made a profit. Using your company's net profit, you can also see how effectively you control overhead expenses.
For instance, if your gross profit is positive but your net profit is negative. It means you have a good product, but your overhead expenses keep you from making money. It also means that your good product may not be able to generate enough revenue to cover your overhead costs.
Thus, your net profit shows whether your company can make more than it spends. Your net profit can be a helpful tool for determining when to cut costs. Monitoring your net profit can help you figure out how much income you have.
It can also help you determine whether there is room for expansion. In addition, decide whether you need additional funding to keep the business running.
Differences Between Gross Profit and Net Profit
There are significant differences between Gross profit and Net Profit. Listed below are the key distinctions between gross profit and net profit:
- Metrics Considered: Gross profit considers income and expenses directly related to the product. On the other hand, net profit considers all business income and expenses.
- What it measures: Gross profit measures the ability of a company to build and produce products efficiently. Net profit measures the overall company's ability to turn a profit.
- How to use it: You can use the gross profit to assess development, sales efficiency, and continued ability to turn a profit. On the other hand, you can use the net profit to evaluate the overall company's financial health by looking at the bottom line.
Operating profit is another common type of profit that refers to the profit of your business before you pay interest and income taxes. It is the reason why it is also known as Earnings Before Interest Or Taxes (EBIT). Operating profit includes expenses like depreciation, which is the gradual decline in asset value.
It does not include income from non-core business activities like asset sales or interest earned from accounts. Businesses usually carry different debts from credit cards and loans that can reduce profits. However, your operating profit can provide an accurate, and a more representation of how well your business is doing by removing interests on those debts.
A high debt load, for instance, can result in both a positive operating profit and a negative net profit or net burn (burn rate). It indicates that your company's core operations are sustainable, and using this information can enable you to improve your financial decision-making.
How to Track and Increase Profit Margins
Before you increase your net profit margins, you must establish a baseline of your current profits and a way of consistently measuring them first. The following are some of the tips for tracking and increasing your profit margins:
#1. Carry out a Regular Finance Check
#2. Automate Your Monitoring
#3. Keep Track of Changes Over Time
Get Real-Time Visibility of Net Profits and Gross Profits
Making the most of your financial analysis as a business owner requires looking at current profit information. However, most early-stage startups cannot afford to devote significant time to analyzing business finances. But you can check the real-time metrics for your gross and net profits.
Net income (net profit)
Furthermore, you can access your business data instantly. You can get information about your business through shareable, easily accessible charts. Thus, making it ideal for internal communications and getting a quick overview of the performance of your business.
Different useful financial dashboards streamline your analysis so you can concentrate on what you do best.
Calculations of Simple Gross Profit vs. Net Profit Are Just the Beginning
Knowing whether you are making a profit or not is not enough. You can identify what is and is not working in your company and make informed decisions by analyzing your profit at various stages of operations.
Your gross profit describes the amount of money you make from your products after expenses. Understanding this figure allows you to determine how effectively your business uses labor and supplies. On the other hand, the net profit uses all business expenses as a more comprehensive measure of your overall financial reporting.
However, keeping track of these financial metrics and getting accessible and effective financial analysis is possible. You can request a personalized demo today to see how we can assist your businesses in monitoring everything in one place in real-time.