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The definition of profit seems simple enough, but in the business world there are two distinct types of profit – gross and net profit. The two are often confused, so we thought we’d explain the difference as part of our series of accounting FAQs.
Gross profit is your business’s income minus the cost of goods sold (COGS). This is where it gets confusing, because it’s easy to get mixed up between COGS and expenses. COGS refers to how much money you spend on making or acquiring the things that you sell – literally the cost of the goods that you sell.
So, if you sell a book, your gross profit is the price which you sell it for, minus the wholesale price that you paid for it. The other expenses which your business incurs aren’t included when you work out the gross profit, but they are for net profit.
Net profits are what’s left from the money you make once the gross profit and all of the other allowable expenses have been deducted. Your expenses might include things like rent, marketing costs, stationery, tax, staff salaries, and so on. Your net profit is the money that you have really made.
Net profit is calculated by working out gross profit, and then deducting allowable expenses from it.
Knowing both your gross and your net profit figures gives a clearer picture of how efficiently the business is operating. You could have a pretty high gross profit figure, but if you have a lot of expenses then your net profit will be much lower.
Knowing what’s happening in each area of the business will help focus attention on the areas that need it most. Beware the perils of taking action based on only your gross or net figures though! Base business decisions only on gross profit, and you could be in for a nasty surprise when it turns out you didn’t make as much as you thought.
Plus, gross and net profit figures are required in order to create income statements and fill in tax returns. Any confusion between the two can mean inaccurate statements, and some unwanted attention from HMRC.
You’ll pay tax on your net profits, whether you’re a limited company or sole trader. Get confused between these and your gross figures, and you’ll pay a lot more tax than you need to. Ouch.
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