Gross profit, net profit & profit margins: what are they, how to calculate them and what's a good one

Gross profit is the amount of money you earn in sales, minus the cost of producing the goods (if a physical product) or the cost of providing the service, that’s also known as the Cost of Goods.

So if you were a baked bean manufacturer the cost of goods would include:

Cost of goods wouldn’t include:

You can talk about gross profit at a company level: the baked bean company made £2,080 gross profit this year.

Or a unit level: the baked bean company made £0.40 gross profit per can.

Gross profit is a very important business metric. It tells you whether your business is profitable or not at its most basic production level.

If you are spending more creating the product or delivering the service than you’re charging for it, your business won’t work out. So it’s important you can sell your product at a high enough price to, at the very least, cover the cost of goods.

If your gross profit is low or negative, you need to find ways to increase your gross profit by doing things like:

Keep in mind that you’ll have other costs outside of the cost of goods figure, such as non-production staff (HR, Finance), office space and marketing costs. The sales income also needs to cover those costs for your business to be profitable - more on that when we cover net profit.

Gross profit and gross profit margin both measure a company’s profitability. But gross profit is displayed in pounds and pence (or your local currency), while gross profit margin is a ratio or percentage.

So the baked bean company might make £0.40 gross profit a can, but their gross profit margin is 66%.

To calculate gross profit:

For example, if it costs you £0.20 to make a can of beans, and you sell the beans for £0.60 a can, your gross profit is £0.40 a can.

If you are currently selling 100 cans a week, or 5,200 per year, your annual gross profit is: £3,120 revenue - £1,040 costs = £2,080 annual gross profit.

To calculate gross profit margin, subtract the cost of goods from the selling price, then divide that number by the selling price, and multiply by 100.

In the beans example: (£0.60 - £0.20 = £0.40) / £0.60 x 100 = 66.66%

It really depends on the industry, specifically how many products you expect to sell and what the profit margin is.

The holy grail is a high margin, high volume product, such as iPhones.

A low profit margin is ok if you sell a high volume of products, for example a high street clothing company.

And a low volume of sales is ok if you sell a high margin product, for example Ferraris.

But where you don’t want to be is selling a low volume of low profit margin products.

The age of the business is another important factor - a new business might have a lower profit margin than a more established one for many reasons:

The Office of National Statistics has data on rates of return by industry, which will give you an idea of what a good profit margin would look like for your industry.

Net profit, or net income as it’s sometimes called, is similar to gross profit in that it’s a measure of business efficiency and profitability – but it’s calculated differently.

Gross profit only takes into account the Cost of Goods. Net profit considers all business costs. This might include marketing and advertising media spend, non-production departments such as marketing, HR and Finance, and office space/equipment costs.

Net profit tells you whether your business as a whole is making money.

You could have positive gross profit, but your net profit margin could be low or even negative. This would mean that you’re making enough money to cover the cost of production of your products/delivery of your services, but not enough money to support your business as a whole.

Taking steps to improve your gross profit could also improve your net profit, but you could also consider doing things like:

However, consider how mature your business is when thinking about net profit. If you’re just starting out you may not be making many sales yet, so need to invest in your marketing activity and possibly offer lower prices while you get established.

This might mean your net profit is low or negative, but will hopefully pay off in the future with a healthy net profit. If your business is more mature and still operating with a low or negative net profit, that may mean something needs to change.

Finally, think about your business plan. Some businesses might sell products on a small scale or in a niche industry, so need a higher net profit margin than companies who sell hundreds of thousands of products. They might not make much money per product (low gross profit margin) but they sell so many that their net profit margin is high.

To calculate net profit:

For example:

This would make your net profit margin 33.33%: (Net income £1,040 / net sales £3,120) x 100 = 33.33

To summarise, gross profit is the money your business makes vs the cost of manufacturing the goods/providing the service. And net profit is the amount of money your business makes taking into account all business costs vs. income.

This article is for information purposes only and does not constitute legal, tax or accounting advice. You should get professional advice if you need help to understand your legal rights or to manage your accounting or tax affairs.

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