Small Business Accounting Guide

23. What is Net Profit and How to Calculate It

Next Read: Accounting 101: How to Calculate Operating Margin


What is Net Profit and How to Calculate It

Apr 27, 2023 • 7 min read
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      As a small business owner, you must track your business’ financial performance. Not only is it necessary to fulfill your financial reporting obligations, but it’s also essential for making informed business decisions.

      The ultimate measure of your business’ performance is its net profit. Here’s what you need to know to calculate the metric and incorporate it into your financial planning.

      What is net profit?

      Net profit refers to the earnings your company retains after paying all its expenses, including costs of goods sold and operating expenses. It’s also commonly referred to as net income and is the last line item at the bottom of the income statement.

      Earning a net profit indicates that your business generated more revenue than it paid in expenses during an accounting period. You refer to the same line item as a net loss when your expenses exceed your revenue.

      Since it captures the final economic result of your business’ activities, net profit is arguably the most meaningful profitability measure. Internal stakeholders, like business managers, need it for everything from calculating tax liabilities to determining owner distributions.

      Similarly, external stakeholders will use it to determine whether they want to work with you. For example, potential lenders might use it to assess whether you can afford additional fixed debt payments. Similarly, a prospective investor might use it to decide whether your business generates adequate returns to justify an investment.

      How do you calculate net profit?

      The net profit formula is straightforward, but calculating it requires gathering all your business’ operational data. Here’s the formula: 

      Net Profit = Net Sales – Cost of Goods Sold – Operating Expenses

      Let’s look at an example to help demonstrate how you’d use the formula to calculate net profit in practice. Say you own a small business that builds and sells custom wooden chairs with the following financial data for 2020:

      • Gross sales: $200,000
      • Refunds: $10,000
      • Direct materials: $30,000
      • Direct labor: $50,000
      • Manufacturing overhead: $10,000
      • Rent: $18,000
      • Utilities: $3,000
      • Professional services: $8,000
      • Marketing: $10,000
      • Supplies: $2,500

      To calculate net profit, you’d use these numbers to fill in the variables in the original formula. Here’s what you’d get:

      $200,000 gross sales – $10,000 refunds = $190,000 net sales

      $30,000 direct materials + $50,000 direct labor + $10,000 manufacturing overhead = $90,000 cost of goods sold (COGS)

      $18,000 rent + $3,000 utilities + $8,000 professional services + $10,000 marketing + $2,500 supplies = $32,500 operating expenses

      Finally, you’d plug each number into the formula and calculate your net profit. Here’s what that looks like:

      $190,000 net sales – $90,000 COGS – $32,500 operating expenses = $67,500 net profit.

      How to calculate net profit margin.

      The net profit margin is a financial metric that compares your net profit to your revenue. Typically expressed as a percentage, you’d use the following formula to calculate it: Net Profit Margin = Net Profit ÷ Net Revenue.

      To demonstrate, let’s use the same numbers from the example in the previous section. In that scenario, here’s how you’d calculate your net profit margin:

      $67,500 net profit ÷ ($200,000 gross sales – $10,000 refunds) = 36% net profit margin

      Net profit margin is an especially useful metric for comparing your economic results to others in your industry. If yours is significantly lower than your competitors’, you probably have operational inefficiencies and should perform additional financial analysis to identify them.

      Where can you find your net profit?

      Your net profit is the last line item on your income statement, so you typically don’t have to calculate it by hand. Instead, most modern businesses use accounting software to track their activities and create an income statement, which culminates in their net profit.

      Notably, it’s a good idea to review your net profit at least every quarter to catch potential issues early and ensure your profitability grows as expected.

      What is the difference between gross profit and net profit?

      Net profit is the last line item on your income statement and refers to the earnings remaining after accounting for all your expenses. Gross profit is near the top of the income statement and refers to the earnings remaining after subtracting COGS.

      In other words, your operating expenses are the difference between your gross and net profit. As a result, the two line items are useful for gaining insight into different aspects of your business.

      Generally, analyzing your gross profit helps you investigate your prices, sales volume, and production costs. Meanwhile, analyzing your net profit is better for evaluating the impact of strategic business decisions on your business’ profitability overall.

      Of course, these profitability measurements are always most insightful when you use them in combination with each other and other financial metrics to lend additional context to your results.

      How to improve net profit.

      Because your net profit is the ultimate financial result of your business’ operations over a given accounting period, anything you do to increase your profitability will help you improve it.

      Since there are infinite ways to increase the line item, you should conduct financial analysis to find the most profitable and readily available opportunities.

      For example, say that you calculate your gross profit margin for the year, which equals your gross profit divided by your net revenue. You find that yours is 40%, but the average for your industry is 65%.

      Upon further investigation, you realize that not only are your prices lower than those of your top competitor, but you’re also spending significantly more on materials than they are. As a result, you mark up your prices slightly and look for a new primary supplier.

      Another effective tactic is to perform regular budget variance analysis. That involves comparing your actual expenses to your expected spending levels, investigating any unfavorable differences, and taking steps to rectify them or adjusting the budget.

      For example, say you find that you’re spending significantly more than you expected on equipment repairs. Therefore, you implement a more proactive maintenance program to help reduce wear and tear on your machinery.

      About the author
      Nick Gallo, CPA

      Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.

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