Gross Vs. Net Profit

Both, gross and net profit are used in prime steps for the calculation of profit made by a business or a venture in a said accounting period. However, before we go on to the difference between them, let us look at some business conventions regarding derivation of profits in an accounting period.

Any establishment which is engaged in any kind of economic or business activity tends to calculate a profit at the end of an accounting year. This profit calculation can take place on a daily, weekly, monthly, quarterly (every three months), 6 monthly, or on an annual basis. This frequency of calculation principally depends upon the working of the business organization.

Now there are two 'accounts' or financial statements made by business organizations. The first one is the production or trading account, which signifies the incomes and expenditures that are directly related to the operation.

For example, if a business concerns the manufacturing of furniture, then the salary of craftsmen and cost of wood purchased become the direct expenditures, while the direct income would include the sale of finished furniture.

The second statement includes secondary or overhead costs such as repairing of power tools, cost of advertising, and taxes. Indirect incomes would include the sale of scrap material or interest on the bank balance.

The direct incomes and expenditures play a large role in calculation of both the profits. The reason that these profits are calculated is that it gives the business managers a good overview of the performance and standing of the business, and contributes to financial management.

Now, one might argue that there are some incomes and expenditures that occur at a fixed rate, only once a year, like taxes. However, with the help of simple arithmetic divisions, this expenditure can be split into smaller subsets such as taxes payable per week or month. With these two statements or rather accounts, one can derive gross profit and net profit. The cash flow of the business can also be derived with the help of this accounting.

The gross profit is calculated by deducting the expenditures from incomes.

Therefore,
Gross Profit = Direct Incomes - Direct Expenditures

In this case, direct incomes would include sales, while direct expenditures would include purchases of material and direct wages.

Net Profit = Gross Profit + Indirect Incomes - Indirect Expenditures

The second statement includes indirect overheads and indirect incomes; i.e. they are not direct participants in the production process. The net profit is calculated by deducting the indirect expenditures from the indirect incomes and then adding the gross profit to the sum.