Do you know the difference between Net vs. Gross Income? It could make a difference to your business accounting.
- Gross income is the entire amount of money made by selling products and services over a certain time period.
- The amount of money left over after all expenditures have been paid is known as net income.
- Knowing the difference between the two is essential to understanding the financial health of your company.
- This article is intended for business owners who wish to streamline their accounting procedures and have a deeper understanding of their company’s profitability.
While a company’s gross income is just its total sales during a certain time period, its net income is the sum of all profits made during that time. The sum of a company’s costs incurred during the covered period is equal to the difference between its net income and gross income.
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Understanding the distinction between net and gross income is crucial for small business owners because it’s the only way they can determine how much money their company produces, which has an impact on planning and budgeting. Managers have no way of knowing if their road to enhanced profitability entails raising sales or reducing costs without understanding the difference between net and gross.
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What is gross income?
Gross revenue is the amount a business produces before deducting any costs, whether they are one-time costs like cost of goods sold that are directly related to a specific product or recurring costs like administrative staff pay.
In essence, a company’s gross income is equal to all of its sales during a specific time period.
Importance of gross income in business
Owners and managers of businesses must routinely add up sales throughout a range of time frames, including weekly, monthly, quarterly, and yearly, in order to manage their finances. Managers can monitor the expansion (or decline) of their sales of various goods and services by doing this.
Before deducting any costs, business owners must examine their earnings throughout several time periods. The average size of sales and seasonality can only be tracked in this way over time.
In order to calculate gross income, managers must also keep track of their staff members’ sales targets and productivity standards. Instead of focusing on profitability, managers might examine a company’s gross income to monitor its sales volume.
Example of gross income
Consider a clothing retailer that sells $250,000 worth of apparel in a quarter. The store’s total revenue for that quarter is $250,000, before any costs are subtracted.
The gross income of a company is a fairly simple concept. It is equivalent to the total annual sales of the business. Managers only need to run a report for the total money collected over a certain period of time to report gross income using any readily available accounting software.
What is net income?
Net income, as opposed to revenue, is the amount of money a firm produces over a period of time after it takes into account all of the costs it spent during that same period. Regardless of how much they sold in goods and sales, without calculating net income, a business owner has no means of knowing if they truly gained or lost money during a specific period of time.
Importance of net income in business
Since it takes into account both revenues and expenditures incurred within the same time period, net income is crucial for determining a company’s profitability.
Businesses should monitor net income in addition to gross income so they can gauge their profitability over time rather than simply their revenue (total sales). A company’s profit margin, or the amount of profit it generates for every dollar of sales, may be calculated by taking its net income and dividing it by its gross revenue.
More significantly, figuring out net income enables managers and small business owners to choose whether to increase sales or decrease costs in order to increase profitability and cash flow.
And probably most significantly, because it is taxed, net income is a vital number for business owners to compute and monitor.
Example of net income
Let’s stick with the retail outlet example from earlier that had quarterly sales of $250,000. Let’s imagine the store’s merchandise had a total cost of $115,000 to buy (inventory cost). Let’s also assume that the sum of rent and utilities costs was $15,000, the sum of employee compensation was $25,000, and the sum of supplies and other miscellaneous costs was $5,000.
The store’s net profit in this instance would be $90,000 ($250,000 – $115,000 – $25,000 – $15,000 – $5,000). That sum represents the store’s overall profit for the quarter, or its revenue less all of its outgoing costs. This figure alone is significant since it informs the owners and management of the shop how much money they made throughout the quarter after costs. When contrasted to net income from earlier periods, such as the same quarter a year before, it becomes even more significant.
Additionally, net income is crucial since it enables the owners and managers of the shop to determine their net profit margin. The store’s profit margin in this scenario would be 36% ($90,000 divided by $250,000). This indicates that the shop made 36 cents in profit for the time period for every $1 in sales it generated.
When to use net vs gross income
Measuring profitability
For assessing overall sales and tracking over time, company managers might utilize the statistic of gross revenue. If, for example, there are some months, quarters, or days of the week that are greater than others, it’s useful for figuring out their market share as well as patterns and seasonality of their sales.
A useful way for business owners to determine the efficiency of their sales team and to establish goals and objectives is to look at gross income. However, it doesn’t indicate to owners or managers if they truly gained or lost money over a specific time period.
On the other hand, net income is a far better metric for monitoring a company’s profitability, or how much money the organization is generating (or losing) over specific time periods. Although net income doesn’t inform business owners or managers if their sales are increasing or decreasing, it does assist them find methods to make their company better (such as by growing sales or cutting expenses).
Calculating profit margin
Firms may measure their profit margin over time to see whether their company is growing more or less lucrative for every dollar of sales. Net income is also a preferable starting point for businesses when calculating their profit margin.
Valuing a business
Finally, net income is preferable for evaluating enterprises, assessing a business’ loanability, and making hiring or investment decisions.