From Business News Daily By Dock David Treece
Do you know the difference between net income and gross income? It could make a difference to your business accounting.
- Gross income is the total revenue derived from sales of goods and services in a specified period.
- Net income is the profit left after deducting total expenses from gross income.
- Understanding the difference between the two is key to understanding your business’s financial health.
- This article is for entrepreneurs who want to improve their accounting process and better understand their business’s profitability.
A business’s net income is its total profit over a period of time, while gross income is simply its total sales over the same period. The difference between a company’s net and gross income is equal to its total expenses incurred during the covered period.
It’s important to understand the difference between net and gross income because it’s the only way small business owners can understand how their business makes money, which affects budgeting and planning. Without discerning between net and gross, managers have no way of knowing whether their path to increased profitability involves increasing sales or cutting costs.
What is gross income?
Gross income is the amount a company makes before accounting for any expenses – either those like cost of goods sold that are directly allocable to a particular product or fixed expenses like salaries for administrative staff.
Essentially, a company’s gross income is equal to its total sales over a set period of time.
Importance of gross income in business
In managing their business’s finances, owners and managers need to periodically total their sales over various periods of time, including weekly, monthly, quarterly or annually. Doing this allows managers to track the growth (or contraction) of their sales of various goods and services.
When business owners review their revenue over various periods, they need to do so before deducting any expenses. That’s the only way they can track their sales over time, the average size of sales and seasonality.
It’s also important for managers tracking employees sales quotas and productivity requirements to measure gross revenue. Gross income helps managers to track a business’s sales volume, as opposed to profitability.
Example of gross income
Imagine a retail clothing store that sells $250,000 worth of clothes over the course of a quarter. That $250,000, before any expenses are deducted, is equal to the store’s gross income for that quarter.
A business’s gross income is relatively straightforward. It’s equal to the company’s total sales over a period of time. Gross income is extremely easy to report using any off-the-shelf accounting software – all managers have to do is run a report for the total income received over a set period of time.
Key takeaway: Gross income measures the total amount of revenue brought in via sales in a given period of time.
What is net income?
Net income is the amount of money a company makes over a period of time after it accounts for all of its expenses incurred over that same period – it’s profit as opposed to revenue. Without calculating net income, a business owner has no way of knowing whether they actually made or lost money over a set period of time, regardless of how much they sold in goods and sales.
Importance of net income in business
Net income is extremely important for measuring the profitability of a business; since it accounts not just for sales, but also for costs incurred over the same period.
It’s important for businesses to track net in addition to gross income so that they can measure their profitability over time, as opposed to just their revenue (total sales). Determining net income also allows companies to calculate their profit margin (net income as a percentage of gross revenue) – in other words, how much the company makes in profit for every dollar of sales.
Even more importantly, calculating net income helps managers and small business owners to determine how to make their business more profitable and improve cash flow – by growing sales or cutting expenses.
And – perhaps MOST importantly – net income is a significant metric for business owners to calculate and track because it is taxable.
Example of net income
Let’s continue with our example of the retail store with $250,000 of sales over a particular quarter. Now, let’s say that the items the store sold cost a total of $115,000 to purchase (inventory cost). Let’s also say that the total cost of employee wages over that period is $25,000, rent and utility expenses totaled $15,000, and supplies and other miscellaneous expenses equaled $5,000.
In this case, the net income for the store for this period would be $90,000 ($250,000 – $115,000 – $25,000 – $15,000 – $5,000). That’s the amount of profit the store earned over that quarter – the amount of money it made over that period, minus all its expenses.
This number is important on its face because it tells the store’s owners and managers how much money they made over the quarter, after expenses. It’s even more important when compared to net income from previous periods – the same quarter a year prior, for example.
And net income is important because it allows the store’s owners and managers to calculate their net profit margin. In this case, the store’s profit margin would equal $90,000 divided by $250,000, or 36%. This means that for every dollar of sales the store achieved, it netted 36 cents in profit for the period.
Key takeaway: Net income measures profitability, deducting total expenses from gross income to show how much profit a business made in a given period of time.
When to use net vs gross income
Gross income is a good metric for business owners to use for measuring their total sales and tracking over time. It’s also good for determining their market share, as well as trends and seasonality of their sales if there are some months, quarters, or days of the week that are stronger than others, for instance.
Gross income is also good for business owners to gauge the effectiveness of their sales staff and set quotas and targets. But it doesn’t tell managers or owners whether they actually made or lost money over a given period of time.
Net income, on the other hand, is a much better number for tracking the profitability of a business, or how much money the company is making (or losing) over given periods of time. Net income doesn’t tell owners or managers whether their sales are going up or down, but it does help them identify ways to improve their business (such as by growing sales or cutting expenses).
Calculating profit margin
Net income is also better for businesses to use in calculating their profit margin, which they can track margin over time to see if the business is becoming more or less profitable for every dollar of sales.