Net and gross income are two of the most important accounting metrics that small business owners must track. Both numbers are essential pieces of the budgeting and planning puzzle. Without discerning the difference between net and gross income, managers have no way of knowing whether their path to increased profitability involves increasing sales or cutting costs.
To understand how your business makes money, you must understand the difference between gross and net income. We’ll explain these crucial accounting figures and share when to use gross and net income in your accounting practices.
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What is gross income?
Gross income is the amount a company makes before accounting for expenses, such as cost of goods sold, which are directly allocable to a particular product or fixed expenses, such as salaries for administrative staff.
Essentially, a company’s gross income is equal to its total sales over a set period.
Importance of gross income in business
When managing business finances, owners and managers must total their sales over various periods, including weekly, monthly, quarterly or annually. These calculations allow them to track the growth (or contraction) of their sales of various goods and services.
When business owners review their revenue over various periods, they must do so before deducting business tax expenses to track sales over time, the average size of a sale and seasonal period. Managers should also track employees’ sales quotas and productivity requirements to measure gross revenue.
Gross income helps managers track a business’s sales volume, not profitability.
Example of gross income
Imagine a retail clothing store that sells $250,000 worth of clothes over a quarter. Before any expenses are deducted, that $250,000 is the store’s gross income for that quarter.
A business’s gross income is relatively straightforward. It’s equal to the company’s total sales over a specific period.
Did You Know?
Gross income is extremely easy to report using any off-the-shelf accounting software. All managers have to do is run an accounting report for the total income received over a set period.
What is net income?
Net income is the amount a company makes over a specific period after accounting for all expenses incurred over that same period. It is profit as opposed to revenue. Without calculating net income, a business owner can’t know whether they made or lost money over a set period, regardless of how much they sold.
Importance of net income in business
Net income is critical for measuring a business’s profitability. It accounts for sales and all costs incurred over the same period.
Businesses must track net income to measure their profitability over time instead of just revenue (total sales). Determining net income also allows companies to calculate their profit margin (net income as a percentage of gross revenue); in other words, how much profit the company makes for every dollar of sales.
More importantly, calculating net income helps managers and small business owners determine how to make their businesses more profitable as well as improve cash flow. To do this, they may need to increase sales or cut business expenses.
Perhaps above all ― net income is a significant 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 over a particular quarter. Now, let’s say the store sold items that cost $115,000 to purchase (inventory cost). Let’s also say that the total cost of employee wages over that period was $25,000, rent and utility expenses totaled $15,000 and supplies and other miscellaneous expenses equaled $5,000.
In this case, the store’s net income for this period would be $90,000 ($250,000 – $115,000 – $25,000 – $15,000 – $5,000). That’s the profit the store earned over that quarter.
This number is crucial because it tells the store’s owners and managers how much money it made over the quarter after expenses. It’s even more important when compared to net income from previous periods ― the same quarter a year prior, for example.
Net income is critical because it allows the store’s owners and managers to calculate the business’s net profit margin. In this case, the store’s profit margin would equal $90,000 divided by $250,000, or 36 percent. This means that for every dollar of sales the store achieved, it netted 36 cents in profit for the period.
FYI
If you’ve ever heard someone refer to the accounting term “bottom line,” they’re talking about net income.
When to use gross vs. net income
Understanding when to use net vs. gross income can help companies plan their business budgets and know when to cut costs or increase sales. Here’s a look at when to use net and gross income in essential accounting scenarios.
Measuring profitability
When analyzing sales data to measure profitability, gross income is a good metric for business owners when they want to do the following:
- Measure total sales and tracking over time
- Determine market share
- Identify sales and retail trends
- Identify sales seasonality (for example, if some months, quarters or days of the week are stronger than others)
- Gauge sales staff effectiveness
- Set quotas and sales targets
However, while it provides insights into all of the above, gross income doesn’t tell managers or owners whether they made or lost money over a given period.
In contrast, net income is a much better number for tracking a business’s profitability or how much money the company is making (or losing) over given periods. Net income doesn’t tell owners or managers whether their sales are going up or down, but it does help them identify ways to improve their business, such as by growing sales or cutting expenses.
Calculating profit margin
Net income is the appropriate metric for businesses that want to calculate their profit margin. Businesses can track their profit margins over time to see if they’re becoming more or less profitable for every dollar of sales.
Valuing a business
Lastly, net income is also better for finding your business’s value, determining a company’s creditworthiness for getting a loan and making investment or hiring decisions.
The best accounting software for calculating and tracking net and gross income
With the right tools, tracking your business’s net and gross income is easy. Check out our picks for the best business accounting software to streamline your accounting checklist.
Some top options for small businesses include the following:
- Intuit QuickBooks Online: QuickBooks Online’s expense and profitability tracking features make it easy to track and analyze your cash flow. Learn more in our Intuit QuickBooks Online accounting software review.
- Xero: With Xero’s financial reporting and data analytics tools, you’ll have everything you need to plan for your long-term financial health. Read about all the features you’ll have access to in our Xero accounting software review.
- Plooto: This accounting software platform allows you to create custom workflows, so expenses are automatically approved and you have a real-time picture of your net income. Find out more in our Plooto accounting software review.
Gross and net income: the building blocks for measuring success
If you want a panoramic view of your business’s financial health, you need to understand the roles that gross and net income play. With both metrics, you get a clear idea of your total sales and profitability after all expenses. When it comes to defining how well your business is doing, gross and net income are two of the most essential ingredients.
Natalie Hamingson contributed to this article.
