- Gross income is the total income from the sales of goods and services during a given period.
- Net income is the profit that remains after deducting total expenses from gross income.
- Understanding the difference between the two is essential to understanding the financial health of your business.
- This article is for entrepreneurs who want to improve their accounting process and better understand the profitability of their business.
The net income of a business is its total profit over a period of time, while the gross income is simply the total of its sales over the same period. The difference between the net income and the gross income of a business is equal to the total of its expenses incurred during the period covered.
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Understanding the difference between net income and gross income is important because this is the only way small business owners understand how their business makes money, which affects budgeting and planning. Without distinguishing between net and gross, managers have no way of knowing whether their path to increased profitability involves increasing sales or reducing costs.
[Learn more about how accounting software can help you track your expenses and calculate your net income]
What is gross income?
Gross revenue is the amount a business realizes before it recognizes expenses, whether it’s the cost of goods sold directly attributable to a particular product or fixed expenses such as administrative staff salaries.
Essentially, a business’s gross income is equal to its total sales over a period of time.
Importance of gross income in the business
In managing their business finances, owners and managers need to periodically total their sales over different time periods, including weekly, monthly, quarterly, or annually. This allows managers to track the growth (or contraction) of their sales of various goods and services.
When business owners look at their income over different time periods, they should do so before deducting expenses. This is the only way they can track their sales over time, average sales size, and seasonality.
It is also important for managers to track employee sales quotas and productivity requirements to measure gross income. Gross income helps managers track a company’s sales volume, as opposed to profitability.
Example of gross income
Imagine a retail clothing store that sells $ 250,000 worth of clothing in a quarter. This $ 250,000, before expenses are deducted, is the store’s gross revenue for that quarter.
The gross income of a business is relatively simple. This is equal to the company’s total sales over a period of time. Gross income is extremely easy to report using any standard accounting software.
To remember : Gross revenue measures the total amount of revenue generated from sales during a given time period.
What is net income?
Net income is the amount of money a business earns over a period of time after accounting for all of its expenses incurred during that same period – it is profit as opposed to income. Without calculating net income, a business owner has no way of knowing if he has actually made or lost money over a period of time, no matter how much he has sold in property and in sales.
Importance of net income in the business
Net income is extremely important in measuring the profitability of a business; since it not only represents sales, but also costs incurred over the same period.
It is important for businesses to track net income in addition to gross income so that they can measure their profitability over time, as opposed to just their income (total sales). Determining net income also allows businesses to calculate their profit margin (net income as a percentage of gross income) – in other words, how much profit the business makes for every dollar of sales.
Most importantly, calculating net income helps managers and small business owners determine how to make their business more profitable and improve cash flow – by increasing sales or reducing expenses.
And – perhaps the MOST important – net income is an important 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 in sales in a particular quarter. Now let’s say the items the store sold cost a total of $ 115,000 to buy (inventory cost). Let’s also say that the total cost of employee salaries during this period is $ 25,000, rent and utilities expenses were $ 15,000, and supplies and other miscellaneous expenses were $ 5. $ 000.
In this case, the store’s net income for that period would be $ 90,000 ($ 250,000 – $ 115,000 – $ 25,000 – $ 15,000 – $ 5,000). This is the amount of profit the store made in that quarter – the amount of money it made in that time period, minus all of its expenses.
This number is important at first glance because it tells store owners and managers how much money they made in the quarter, after spending. This is even more important when compared to net income from previous periods – the same quarter of the previous year, for example.
And net income is important because it allows store 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 in sales made by the store, it made a profit of 36 cents for the period.
To remember : Net income measures profitability, by deducting total expenses from gross income to show the profit made by a business during a given period.
When to use net income versus gross income
Gross income is a good metric that business owners can use to measure their total sales and track over time. It’s also good for determining their market share, as well as the trends and seasonality of their sales if certain months, quarters, or days of the week are stronger than others, for example.
Gross income is also good for business owners to gauge the effectiveness of their sales staff and set quotas and goals. But that doesn’t tell managers or owners if they’ve actually made or lost money over a period of time.
Net income, on the other hand, is a much better number for tracking a company’s profitability, or how much money the business is making (or losing) over given time periods. Net income doesn’t tell owners or managers if their sales are increasing or decreasing, but it helps them identify ways to improve their business (for example, by increasing sales or reducing expenses).
Calculation of profit margin
Net income is also better for businesses to use in calculating their profit margin, which they can track over time to see if the business is getting more or less profitable for every dollar it sells.
Valuing a company
And, finally, net income is also better for valuing businesses, determining a business’s creditworthiness for obtaining a loan, and making investment or hiring decisions.