Gross profit and net profit
Two different measures of profit, and the difference between them is what most questions here turn on.
gross profit = revenue − cost of sales
Cost of sales is what it cost to produce or buy the goods that were sold — materials and direct production costs. Gross profit is therefore the profit made on the products themselves, before any of the running costs of the business are taken off.
net profit = gross profit − other operating expenses and interest
Other expenses are the costs of running the business rather than making the product: rent, salaries, insurance, marketing, energy. Net profit is what is actually left.
Net profit is always the smaller of the two, and it is the more meaningful figure — a business can have a healthy gross profit and still make a net loss if its overheads are too high.
Worked example
A business has revenue of £180 000, cost of sales of £108 000, and other operating expenses of £54 000. Calculate gross profit and net profit.
- Gross profit = revenue − cost of sales = 180 000 − 108 000.
- = £72 000.
- Net profit = gross profit − other operating expenses = 72 000 − 54 000.
- = £18 000.
- Check the relationship: net profit is smaller than gross profit, as it must be.
Answer: Gross profit £72 000 and net profit £18 000.
Common mistake
Subtract other expenses from gross profit, not from revenue again. Taking every cost off revenue in one step gives the right answer only by accident — and gives the wrong one whenever a question asks for both figures.
- Gross profit
- revenue minus cost of sales; the profit made on the goods themselves, before the running costs of the business
- Net profit
- gross profit minus all other operating expenses and interest; what the business actually keeps
- Cost of sales
- what it cost to produce or buy the goods that were sold — materials and direct production costs
Profit margins
A margin expresses profit as a percentage of revenue, which allows comparison between businesses of different sizes and between years.
gross profit margin = (gross profit ÷ revenue) × 100 net profit margin = (net profit ÷ revenue) × 100
Both divide by revenue, not by cost — that is the error to guard against.
What they tell you:
• Gross profit margin shows how much profit is made on the products themselves. A low figure means the business is either charging too little or paying too much for materials. • Net profit margin shows how much of each pound of revenue the business finally keeps. A healthy gross margin with a poor net margin points to high overheads rather than a problem with the product.
Comparing the two is what makes them useful, and it tells you where to look for the problem.
Worked example
Using the figures above, calculate both margins and interpret them.
- Gross profit margin = (72 000 ÷ 180 000) × 100.
- = 40%.
- Net profit margin = (18 000 ÷ 180 000) × 100.
- = 10%.
- Interpret: 40p of every pound is profit on the product, but only 10p survives after running costs — so 30p in every pound goes on overheads.
Answer: Gross profit margin 40%, net profit margin 10%. The product itself is profitable, but overheads consume three quarters of that gross profit — so the place to look for improvement is running costs rather than pricing or suppliers.
How margins are improved:
Gross profit margin — raise the price, or reduce the cost of sales by finding cheaper suppliers, negotiating better terms or reducing waste. Each has a risk: raising the price may lose customers, and cheaper materials may reduce quality.
Net profit margin — anything that improves the gross margin, plus reducing overheads: cheaper premises, lower energy use, more efficient staffing, less spending on promotion. The risk is cutting something that turns out to matter, such as marketing or staff.
What counts as a good margin depends entirely on the industry, so margins are only meaningful compared with the same business over time or with a direct competitor.
- Gross profit margin
- gross profit divided by revenue, expressed as a percentage
- Net profit margin
- net profit divided by revenue, expressed as a percentage
Average rate of return
The average rate of return (ARR) measures how profitable an investment is, expressed as a percentage per year. It lets a business compare one possible investment against another, or against simply leaving the money in the bank.
The calculation has two steps:
average annual profit = total profit ÷ number of years average rate of return = (average annual profit ÷ cost of investment) × 100
Worked example
A machine costs £60 000 and is expected to generate total profit of £84 000 over five years. Calculate the average rate of return.
- Average annual profit = total profit ÷ years = 84 000 ÷ 5.
- = £16 800 per year.
- ARR = (average annual profit ÷ cost of investment) × 100 = (16 800 ÷ 60 000) × 100.
- = 28%.
- Interpret: the machine returns 28% of its cost each year on average, far more than a bank would pay in interest.
Answer: 28% per year. That is well above typical interest rates, so on this measure the investment looks worthwhile.
Interpreting ARR: a higher figure is better, and a business will normally compare it with the interest it could earn by saving the money, or with the interest it would pay on a loan to fund it. If the ARR is lower than the cost of borrowing, the investment loses money.
Its limitations matter for evaluation questions: it is based on forecast profits that may not happen; it ignores when the profits arrive, so £84 000 arriving mostly in year five counts the same as arriving in year one; and it takes no account of non-financial factors such as the effect on staff or the environment.
- Average rate of return
- ARR: a measure of how profitable an investment is, expressed as a percentage per year, calculated as average annual profit divided by the cost of the investment × 100
Before you practise
- gross profit = revenue − cost of sales.
- net profit = gross profit − other operating expenses and interest.
- Net profit is always smaller, and is the more meaningful figure.
- Both margins divide by revenue and multiply by 100.
- A healthy gross margin with a poor net margin means overheads are the problem, not the product.
- average rate of return = (average annual profit ÷ cost of investment) × 100, where average annual profit is total profit ÷ years.
- Compare ARR with interest rates to judge whether an investment is worthwhile.
- ARR relies on forecasts, ignores when profits arrive, and ignores non-financial factors.
- Show your workings — calculation questions award marks for method as well as answer.