Gross profit vs net profit: the difference, with a worked example

Short answer: gross profit is sales minus the direct cost of making those sales (stock, materials, subcontractors on a job, shipping out). It tells you whether what you sell is priced well above what it costs you. Net profit is what is left after every cost: gross profit minus overheads like wages, rent, software, advertising, depreciation and interest. It tells you whether the business as a whole made money. A business can have a healthy gross profit and still make a net loss, if its overheads are bigger than its gross profit. In Xero’s Profit and Loss, Gross Profit is the line after Cost of Sales, and Net Profit is the last line. Both start from sales, also called turnover: turnover vs profit shows why a busy business can still keep very little.

The two formulas

• Gross profit = sales − cost of sales
• Gross margin % = gross profit ÷ sales × 100
• Net profit = gross profit + other income − operating expenses
• Net margin % = net profit ÷ sales × 100

On £100,000 of sales with £40,000 of cost of sales and £45,000 of overheads, gross profit is £60,000 (a 60% gross margin) and net profit is £15,000 (a 15% net margin). The gross margin is always the higher of the two, because net profit has more costs taken off. In between sits the operating margin, before loan interest and tax; operating profit margin works out the margin a business needs and how much cushion it gives.

	Gross profit	Net profit
Costs taken off	Only the direct cost of what was sold	Every cost on the Profit and Loss
Question it answers	Is my pricing and product cost right?	Did the business make money?
Moves when	Prices, supplier costs, discounts, wastage or the mix of what sells change	Any of those, plus wages, rent, marketing and every other overhead
In Xero	The Gross Profit line, after Cost of Sales	The Net Profit line at the bottom
Also called	Gross income, trading profit	The bottom line, net income, net earnings

To see both from your own figures, the free profit and loss sheet lays out sales, cost of sales and running costs and shows gross profit, net profit and both margins as you type. “Trading profit” is used for gross profit in an old-style trading account, but HMRC and most accountants mean something else by it; trading profit explains the three meanings and the tax on a sole trader’s trading profit. For the lines in between (operating profit, EBITDA, profit before tax and retained profit), types of profit works one company’s year through all of them. In Xero, Net Profit during the year is usually before tax; profit before tax shows how much of it the tax takes (about a quarter for most small companies).

Where Xero shows each one

Run Accounting › Reports › Profit and Loss. Xero lays it out as Trading Income, then Less Cost of Sales, then Gross Profit, then Other Income, then Less Operating Expenses, then Net Profit. The Executive Summary report shows gross and net margin as percentages. Menu names move between Xero releases and differ slightly by region; if a label does not match your screen, search Xero Central for the report name.

Which section a cost lands in depends on its account type in the chart of accounts. Accounts of type Direct Costs go above the Gross Profit line; Expense, Overhead and Depreciation accounts go below it. If your report has no Gross Profit line, nothing is coded to a Direct Costs account yet. Moving an account between the two changes gross profit but never net profit. The gross profit margin in Xero guide covers finding and fixing the margin in more detail, and how to read your Profit and Loss in Xero goes through every section.

What usually counts as cost of sales

Above the line (cost of sales): stock or goods you sold, raw materials and ingredients, subcontractors or freelancers paid for a specific job, packaging and shipping to customers, and sometimes card or marketplace fees on each sale. Some trades also put the wages of staff who do the billable work here (a builder’s labourers, a café’s kitchen staff). If you hold stock, cost of sales should be what the goods you sold cost, not what you bought that month: cost of goods sold works through the formula with a shop example.

Below the line (overheads): rent, office and admin wages, the owner’s salary, software, insurance, accountant’s fees, advertising, vehicles, phone and internet, depreciation and loan interest. Most of these are fixed costs, while most costs above the line are variable; fixed and variable costs explains the difference and why it sets your break-even.

The test is whether the cost would go up if you sold one more unit or did one more job. If it would, it is a direct cost. There is some judgement at the edges (shipping, card fees, staff), and the right answer is the one you apply the same way every month, so the margins compare.

A worked example: gross profit up, net profit down

These are made-up figures for a small UK online homeware shop over two years. All amounts exclude VAT.

	Year 1 (£)	Year 2 (£)
Sales	300,000	360,000
Cost of sales (stock, packaging, shipping out)	165,000	190,800
Gross profit	135,000 (45.0%)	169,200 (47.0%)
Wages	60,000	72,000
Rent and storage	12,000	12,000
Advertising	30,000	54,000
Software	6,000	7,200
Other overheads	9,000	10,800
Total overheads	117,000	156,000
Net profit	18,000 (6.0%)	13,200 (3.7%)

The two profit lines tell opposite stories:

• Gross profit says year 2 was better. Sales rose 20% and the gross margin went from 45% to 47%, so each £100 of sales left £47 after stock and shipping instead of £45. Gross profit rose by £34,200. Pricing and buying are working.
• Net profit says year 2 was worse. Overheads rose by £39,000, more than the extra gross profit, so net profit fell by £4,800, from 6.0% of sales to 3.7%.
• The cause is one overhead. Advertising went from £30,000 (10% of sales) to £54,000 (15% of sales), up 80% while sales grew 20%. Wages, software and other overheads grew by 20%, in line with sales, and rent stayed flat. Without the extra £24,000 of advertising, overheads would have been £132,000 and net profit £37,200, if the same sales had still come in.

Looking at gross profit alone, the owner would think the year went well. Looking at net profit alone, they might cut prices or change suppliers, which would be fixing the part that was working. Reading both points at the advertising line. The where is my money going guide shows how to find the overhead that grew fastest, and why did my profit drop goes through the usual causes in order.

Reading the two together

Gross margin	Net margin	What it usually means
Steady	Steady	Nothing has changed. Watch the trend, not the month.
Falling	Falling	Direct costs or discounts are the problem: supplier price rises, wastage, underquoting jobs.
Steady or rising	Falling	Overheads are growing faster than sales: a new hire, rent, ads, subscriptions.
Falling	Steady	Overheads were cut, but each sale earns less. That cannot go on for long.

If the business has loan interest or a one-off gain, also look at the line between the two: operating profit is gross profit minus overheads before interest and one-off items, so it shows the trading result on its own. Compare each month with the month before and with the same month last year, because many businesses are seasonal. A move of 3 percentage points or more in either margin is worth asking about. To see the sales you need to cover your overheads at your current gross margin, use the free break-even calculator. To see what a price rise does to both lines, try the price increase calculator, and the margin and markup calculator turns a markup into a gross margin.

Net profit is not your pay or your bank balance

• It is usually before income tax. A sole trader’s income tax is personal, so it never appears on the business P&L. A company’s tax only shows up if a tax expense is posted, which is usually done once at year end, so during the year Xero’s Net Profit line is normally before tax.
• Owner drawings and dividends come out of it, not before it. They are not expenses, so a sole trader’s net profit is the amount they are taxed on, not what they have already taken out. It also includes nothing for the owner’s own time: true profit takes off a market wage for it to show what the business really makes. How much can I pay myself shows how to size drawings from cash, and the net profit calculator shows how much of the profit stays in the business after drawings and loan repayments.
• It is not cash. Unpaid invoices, stock bought, equipment, loan repayments and GST or VAT all change the bank without changing profit. Profit in Xero but no cash in the bank explains the gap.

Common questions

What is the difference between gross profit and net profit? Gross profit is sales minus the direct cost of those sales, such as stock, materials and subcontractors. Net profit is what is left after all costs, including overheads like wages, rent, software, advertising, depreciation and interest. Gross profit shows whether your product or service is priced well; net profit shows whether the whole business made money.

Which is more important, gross profit or net profit? Net profit is the one that pays the owner and builds the business, but gross profit is the earlier warning. A falling gross margin points at pricing or direct costs; a falling net margin with a steady gross margin points at overheads. Read both every month.

Can gross profit be positive and net profit negative? Yes. If overheads are bigger than gross profit, the business makes a net loss even though every sale earns more than it costs. That is common in a new business, or after a big hire or a rise in rent or marketing.

Is net profit before or after tax? In the strict accounting sense, net profit is after all expenses including tax. In Xero, a sole trader’s Net Profit is always before income tax, because that tax is personal, and a company’s is usually before tax until the year-end tax journal is posted. Ask which one someone means.

Is operating profit the same as net profit? Not quite. Operating profit is gross profit minus operating expenses, before interest and tax. Net profit also takes off interest and, in the strict sense, tax. For a small business with no loans, the two are often the same figure on Xero’s Profit and Loss. EBITDA goes one step further and adds back depreciation and amortisation too; the EBITDA calculator works out operating profit and EBITDA from the same report.

What is a good gross and net profit margin? It depends on the trade. A consultancy with no materials can have a very high gross margin, while a retailer or builder sits much lower, and neither is doing anything wrong. Your own history and businesses in the same trade are the useful comparisons, not a single number.

Both margins every Monday

ReportPilot reads your Xero figures and sends a short email every Monday in plain English. It covers sales and profit against last month and the same month last year, and when cost of sales is coded in Xero and gross margin moves by 3 percentage points or more against the month before, the email says so, with what was left from every $100 of sales in each month. It also covers cash, money owed to you that is past due, and bills due soon. It asks Xero for read-only access, and there is a 14-day free trial with no card.