Earnings of any person or business are always utilized or spent on certain operations for survival. Financial experts prefer classifying income into two broad categories – gross and net – to understand what amount of income is initially earned and what remains. In this article, we will dive deeper into these two, the meaning behind fundamental classifications, and learn how they are treated in finance.
Gross income vs. Net income: What’s the difference?
Before moving on to the differences, let us understand what net income versus gross means. What is the difference between gross vs. net? Gross refers to the total amount of something. Meanwhile, net refers to the total amount that remains after specific relevant and prioritized reductions from the initial amount.
Income is essentially the amount of money left after the deduction of costs. The amount of money you make over a specific product, service, or process is your income from that venture. However, depending on whether you are a business or an individual, you will still have certain pending expenditures that you will need to take care of before spending the money on yourself. It is where the gross income vs. net income comes in.
Gross income is a term used to describe a company’s earnings after deducting the costs of producing and distributing its products. The accounting equation to calculate gross profit is Sales Revenue minus Returns, Allowances, and Cost of Goods Sold. How effectively a business can turn a profit while controlling its production and labor expenses is determined by its gross income. It is also usually referred to as Gross profit.
On the other hand, a company’s net income is its profit after deducting all directly or indirectly related expenditures from sales. So, net income is calculated as gross income less indirect expenditure. Net income is a comprehensive indicator of profitability that sheds light on how effectively the management team manages every facet of the company.
Below are specific terms you will regularly come across when going through finances.
Income from operations
Income and costs from the business’s operations generally include net income vs. gross income for tax reporting and financial statement reasons. Usually, income from other sources, such as investments, is kept separate from this income.
Returns and allowances
Credits are given to customers who return items they have purchased. Allowances are discounts or decreases in a product’s selling price. Refunds in cash or credit are not considered refunds for tax reporting reasons.
Cost of goods sold
The price you pay for the items or services you sell is the cost of goods sold (COGS). It covers the price of materials, labor for creating goods or providing services, and shipping. Before determining gross revenue, COGS or COS are subtracted from the company’s gross receipts.
Due to their direct connection to sales, these expenses stand apart from other corporate fees. You don’t have COGS if your firm is not selling goods.
How to calculate gross income vs. net income?
Gross versus net income (profit) computations differ significantly depending on taxing and accounting contexts.
Schedule C of Form 1040 is a tax form filed to report a business’s income and expenses for tax purposes (used by US taxpayers). Therefore, most companies use it to record their enterprises’ total and net profits. The owner computes their total tax on their tax return by adding their net income to any other income. Let us go through gross and net income one by one.
Gross Income is calculated by subtracting Returns and Cost of Goods Sold and adding Other Income to Gross/Net Revenue.
The formula is below:
Gross Income = Gross/Net Revenue – Returns – Cost of Goods Sold + Other Income
For Net Income, simply subtract Indirect Expense from the Gross Income calculated above.
The formula is below:
Net income = Gross Income – Indirect Expense
Income statement calculation
Every business must develop and utilize an income statement (profit and loss statement) to display the earnings and outlays of the company over a certain period. Based on the requirements of each firm, the structure and content may change.
In comparison to the method used for tax calculations, the major difference is the format:
- Net Sales = Gross/Net Revenue – Returns
- Gross Income = Net Sales – Cost of Goods Sold + Other Income
- Net income = Gross Income – Indirect Expense
Depending on the industry and company entity type, different costs apply.
The expense of purchasing long-term assets is depreciation (like business vehicles and equipment). The cost is dispersed across several years. Schedule C and the Income Statement both include the expense for the current year.
Although they are not tax-deductible, a company’s income statement may include principal loan payments.
Why even bother distinguishing between net income vs. gross income?
Both net income and gross income allow us to gain insights into the performance of a business or household as a monetary unit.
A firm’s capacity to turn a profit while controlling its production and labor expenses is measured by its gross profit. This makes it vital to figure out why a company’s earnings are rising or falling by examining sales, manufacturing costs, labor expenses, and productivity. The gross profit for the period will be lower if a firm reports an increase in revenue that is more than offset by the rise in production expenses, such as labor.
For instance, if a business recruits too few production workers during its peak season, it would have to pay its current employees additional overtime. Higher labor expenses and a decline in gross profitability would be the outcome. However, as gross profit excludes all other expenses related to running a successful firm, it would be incomplete to measure total profitability.
Net income, on the other hand, is a company’s total profit from all business operations. Net income, which is more inclusive than gross profit, can show how well the management team performs.
For instance, a business could boost its profit while mismanaging its debt by taking on excessive debt. Despite the company’s successful efforts in sales and production, the higher interest costs associated with repaying the debt might cause a decline in net income.
Financial ratios such as net profit margins, gross profit margins, and markups are calculated using net Income and gross Income.
The sum of a business’s earnings before costs is its gross income. Following the deduction of sales returns and allowances, it is the business’s revenue from sales (discounts). If your company sells things, figure out your COGS and subtract it to lower your gross income.
In contrast, a company’s net income is its revenue less its costs. Since certain costs are tax deductible and others are not, a company’s net income may fluctuate for accounting and tax purposes.