The difference between gross profit and net profit: a guide for UK SMEs

Every business owner wants to turn a profit. But the type of profit matters. Gross profit tells you how efficiently you use labour and supplies to produce your goods and services. In contrast, net profit is the 'bottom line': it's the money left after all business expenses have been deducted from revenue. Both have a role to play in how you plan and run your business.

In this article, we’ll take a look at the difference between gross and net profit, how to calculate them and how to use them.

What is gross profit?

Your gross profit is calculated by taking your total revenue for the period and subtracting your Cost of Goods Sold (COGS), sometimes also known as your Cost of Sales figure. 

COGS only includes the direct costs of creating or acquiring the products you’ve sold. This will typically include expenses such as raw materials, direct labour, and packaging for a manufacturer, or the purchase price of stock for a retailer. 

In this way, gross profit is your basic measure of how efficiently you’re using your labour and supplies to produce goods and/or services. It isolates your core operational performance before any other overheads are considered.

How to calculate gross profit

Here’s how to calculate your gross profit for a set period:

Gross Profit = Revenue - Cost of Goods Sold (COGS)

For example, if your revenue for the quarter was £200,000, and your COGS figure was £90,000, your gross profit calculation would look like this

£200,000 - £90,000 = Gross Profit of £110,000

What’s a gross profit margin?

Once you've calculated your gross profit, you can also work out your gross profit margin. This is a financial ratio that helps you to analyse and measure the overall financial health of your business. 

To find your gross profit margin, divide your gross profit number by your original revenue and then times it by 100 to get a percentage. 

This is the gross profit margin formula:

(Gross Profit / Revenue) x 100.

What’s a good gross profit margin for a small business?

In general, a gross profit margin of between 50%-70% is considered healthy for most small businesses. Across the whole market, recent studies have shown an average gross margin of 36.56% in a profitable enterprise, but that figure can vary wildly across industries. As a rule of thumb, dipping below this average can be a sign of difficulty, especially for businesses with high operating costs.

Gross profit margins will vary greatly across different industries, with sectors that have low operating costs having much higher margin ratios than those that have high operating costs and smaller gross profit scores.

Here are a few different examples of gross profit margins across a range of industries, demonstrating how margins can fluctuate across sectors:

• Software businesses: The software industry typically has the highest gross profit margins, with an average gross margin of 63.42% for entertainment software and average gross margin of 71.52% for software systems/applications. This is due to the low direct costs associated with a digital product, after you’ve completed the initial development phase. Low operational costs = higher gross profit margins.
• Professional services businesses: Financial services, consulting, legal and insurance firms generally have a strong gross profit margin due to the service-driven nature of their business model. For an insurance firm, the average gross margin is 33.93%, while a financial services business can have an average gross margin of 65.99%. 
• Manufacturing businesses: Manufacturing involves significant costs for raw materials, labour and production. These costs eat into your margin and, as a result, average gross profit margins are typically lower. For example, in paper production the average gross margin is 20.20%, and in shipbuilding the average gross margin is 25.44% due to the high costs and resourcing of producing the end product.
• Retail businesses: Retail margins can vary significantly depending on the product, with an average gross margin of 21.88% for automotive retail companties to an average gross margin of 34.17%, showing the wide range of margins across different retail sectors.
• Construction businesses: The construction industry is known for its narrow profit margins. For example, in the homebuilding sector, the average gross margin is 25.6%, due to the high costs of building materials, labour and specialist building equipment etc.

What is net profit?

Net profit is what’s more commonly known as your ‘bottom line’ – so-called, because it’s literally the bottom line in a profit and loss (P&L) report. 

Your net profit number shows what’s left after all business expenses have been deducted from revenue, not just COGS. It’s the real-world profit you make as a business, and the ultimate measure of whether the business is profitable.

The additional costs you subtract include a number of expenses that are not included within the standard COGS number.

This could include:

• Rent on your office space, that doesn’t fall under your COGS number (renting a factory or manufacturing space to make the product falls under COGS). 
• Business rates that you’re charged by your local authority. 
• Salaries, for non-production staff, like admin and sales, that aren’t part of the manufacturing, production and service delivery teams.
• Marketing costs, including running online campaigns, targeted advertising and any other sales or promotional activity to market the business.
• Professional services fees including the regular fees you pay to your accountant, tax adviser, lawyer or solicitor etc. 
• Energy and utilities costs, like electricity and gas to your business premises. 
• Business insurance, including property insurance, employer liability insurance, public liability insurance and other plans taken out by the business. 
• National Insurance contributions that you pay as an employer.
• Interest on business loans that you pay to your lender. These interest payments may be tax deductible when you complete your annual tax return.
• Depreciation and wear and tear on the company’s key assets.

Your net profit number is the ultimate measure of the business profitability and long-term financial health. 

Net profit shows the money the business has actually made, money that can be reinvested, held as retained earnings, or distributed to your shareholders.

How to calculate net profit

Here’s how to calculate your net profit number:

Net Profit = Gross Profit - (Operating Expenses + Interest + Taxes + Depreciation)

So, if we use our initial gross profit number of £110,000, a net profit example could look as follows:

Gross Profit (£110,000) - (Operating Expenses [£50k] + Interest [£2k] + Taxes [£20k] + Depreciation [£5k]) = Net Profit of £33,000

What’s a good net profit margin?

Your net profit margin shows the percentage of revenue your business keeps as profit once you’ve subtracted all your expenses, including things like operating costs, interest, taxes and depreciation. Your margin is calculated by dividing your net profit by your total revenue. This ratio is a crucial indicator of your company's overall financial health and efficiency:

(Net Profit / Revenue) x 100.

The fewer the costs, and the smaller the expenses that you subtract from your initial gross margin, the better your net profit margin will be. In short, if you spend less, you’ll have a better net profit margin as a business.

Ways to achieve this can include:

• Switching your utility providers to cheaper vendors
• Reviewing your software subscriptions to cut down on unused apps and tools
• Increasing your gross profit by reducing your COGS figure
• Cutting back your use of casual labour to reduce wages

What’s the difference between gross and net profit?

Gross profit is a simple health check of your core business activity – factoring in the costs of making and selling your product. Net profit is the final, true measure of profitability after every single bill, from rent to tax, has been paid.

In terms of usage, differences include:

• Scope: The scope of your gross profit figure is narrow – it’s focused on your core production/service costs only. Net profit is a more comprehensive figure, including all business costs. As such, it gives you a broader understanding of profitability.
• Purpose: Gross profit helps you review and assess the efficiency of your production process, or service delivery. Net profit assesses the overall business viability of the entire company, helping you see whether your business model is delivering profit.
• Reporting: Both gross and net profit appear on the company’s profit and loss report. But your gross profit number will always appear above net profit. Gross profit shows you the figure before most costs are accounted for. Net profit shows you the final profit number and bottom line, once all costs have been subtracted.

How to improve gross and net profit margins

As a core aim, you want your business to be profitable. So any actions you can take to improve your gross and net profit will help with this overarching goal. 

How to improve your gross profit 

To boost gross profit, think about increasing your prices, while remaining competitive in the market. You can also negotiate better rates with your suppliers, reduce material waste, or improve the efficiency of your production staff and resourcing.

How to improve your net profit

All the same tactics that work to boost your gross profit will also increase your net profit. In addition, you can try some proactive steps to reduce your business costs and unneeded expenses. This could include refinancing any existing debt to get a lower interest rate. One way to further reduce costs is to refinance through a specialist finance provider like iwoca, where there are no fees for early repayment of the loan. You could also use technology and AI tools to automate some of your manual admin tasks, cutting down your payroll costs.

How to use business finance to boost profitability

Sometimes it involves spending money to actually see an uptick in your overall profits. One way to do this is to use financial products, like invoice financing or short-term small business loans, to improve your cash flow.

Having more cash in the kitty gives you the means to bulk-buy from suppliers and to negotiate cheaper costs for buying in bulk. Taking out a small business loan from iwoca, gives you the liquid cash needed to achieve these economies of scale. While this means a higher outlay in the short term, in the longer term it means a cost saving – a saving that can be fed back into your gross and net profit margins. 

Do businesses pay tax on gross or net profit?

Corporation tax is calculated based on your net profit before tax (often called Profit Before Tax or PBT).

HMRC has strict rules on what qualifies as an ‘allowable expense’ for tax deduction. Not every business cost can be used to reduce the tax bill. To qualify, expenses must be entirely business-related and allowable under HMRC rules. 

You’ll pay corporation tax on your net profit after all allowable business expenses have been deducted. This is known as your taxable profits and is the figure that HMRC will use to calculate your tax. Gross profit is simply a stepping stone in the calculation.

How businesses use gross and net profit

Your gross and net profit numbers are not just an arbitrary accounting metric. They both tell you something meaningful about the health of your business, not to mention your ability to borrow, invest and grow the company.

Profit figures act as a metric to measure:

• Investor confidence: Potential investors will scrutinise your net profit trends to understand the health and growth potential of a business before investing. Poor profitability could well discourage any risk-averse investors.
• Creditworthiness: UK lenders and credit reference agencies (like Experian, Equifax and Dun & Bradstreet) will use your net profit figures to determine your ability to service and repay loans. A poor net profit number may well limit your ability to borrow and take on lines of credit. 
• Business planning: Your profit for previous periods will be used as the basis for next year’s budgeting. The better your profitability, the more positive your budgeting will be and the more cash flow you’ll have at your disposal. 

iwoca: flexible finance to fund your profit strategy

Short-term, flexible loans are a great way to improve your liquidity and find the cash needed to implement your profit strategy.

An iwoca Flexi-Loan can be in your business bank account in a matter of hours, allowing you to buy in bulk, or fund new equipment to boost productivity.

With an iwoca Flexi-Loan you can:

• Borrow £1,000 to £1 million
• Pay it back from 1 day to 60 months
• Repay early, with no extra fees

Apply for an iwoca Flexi-Loan

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