Net income and gross income are two important profitability metrics that get often used interchangeably. But they denote two different aspects of a company’s earnings. Understanding the distinctions between these two key income figures is essential for analyzing financial statements.
In this article, we will examine gross income versus net income in detail and highlight the key differences between the two.
Defining Gross Income
Gross income, sometimes called gross profit, refers to a company’s total revenues minus the direct costs incurred in generating those revenues. In other words, it represents the profit left over after deducting only the costs directly associated with production.
Here is what comprises gross income:
This refers to all income streams generated from the company’s business activities during a specific period. It includes:
- Sales revenues earned from products or services
- Interest income from investments
- Dividends received
- Any other operating income
These are the direct costs attributable to the production of goods and services:
- Cost of goods sold (COGS) – Materials, labor, and manufacturing overhead costs
- Direct labor costs – Wages of employees involved in production
- Direct material costs – Costs of raw materials or components used to make products
Gross income = Total revenues – Direct costs
So in brief, gross income focuses on profit after deducting only the direct costs of generating income. It does not account for the company’s operating, tax, and other indirect expenses.
Defining Net Income
Net income, also known as net profit, refers to the residual income left after subtracting all direct and indirect expenses from total revenues. It represents the final profit or loss for a company over a period.
Here is what comprises net income:
Same as gross income, this includes all revenues from sales of products/services, investments, assets and other sources.
Same as gross income, this includes COGS and other direct production costs.
These include all the indirect expenses incurred in the company’s operations, like:
- Employee salaries and wages
- Sales and marketing expenses
- Research and development costs
- Depreciation of assets
- Amortization of intangibles
- Administrative expenses
Other peripheral expenses outside of the company’s core operations:
- Interest expenses on debt
- Other indirect capital expenses
Net Income = Total Revenues – Direct Costs – Operating Expenses – Non-Operating Expenses
Net income provides a comprehensive view of the company’s profitability after subtracting all business expenses. It represents the full picture of earnings.
Key Differences Between Gross Income and Net Income
Now that we have defined both terms, let’s examine some key differences between gross income and net income:
1. Expenses Considered
The main difference lies in the expenses each term accounts for:
- Gross income only deducts direct costs of generating revenue.
- Net income deducts all expenses – direct, operating and non-operating costs.
2. Profitability Picture
- Gross income provides a limited view of profitability, ignoring vital indirect costs.
- Net income presents the true profitability of a company after all expenses.
3. Use Cases
- Gross income helps analyze only the revenue-generation activities and production costs.
- Net income helps make strategic decisions, set pricing, manage taxes, determine dividends and value a company holistically.
4. Income Statement Representation
- Gross income is represented on the income statement as Gross Profit.
- Net income is represented on the income statement as Net Income/Net Profit.
5. Trend Analysis
- Analyzing gross income trends helps assess direct production costs and efficiency.
- Net income trend analysis provides a better idea of profitability over time.
6. Performance Evaluation
- Gross income metrics like gross margin help evaluate production-related performance.
- Net income metrics like profit margin are better indicators for overall company performance.
Real Example Comparing Gross and Net Income
Let’s look at a real example to illustrate the difference between gross and net income figures:
Company XYZ has the following income statement:
- Total Revenues: $550,000
- Direct Materials: $100,000
- Direct Labor: $50,000
- Gross Profit = $400,000
- Operating Expenses:
- Rent: $30,000
- Sales Commissions: $10,000
- Salaries: $80,000
- Utilities: $15,000
- Depreciation: $20,000
- Total Operating Expenses: $155,000
- EBIT (Earnings before Interest & Taxes): $245,000
- Interest Expense: $10,000
- Pretax Income: $235,000
- Income Taxes: $60,000
- Net Income = $175,000
Observe how gross profit is $400,000 after only deducting direct costs from total revenues. But net income is lower at $175,000 after accounting for all indirect operating and non-operating expenses too.
This demonstrates why net income presents a company’s true bottom line position while gross income can be misleading if indirect costs are high.
Worth Noting on Gross Income and Net Income
When analyzing and comparing gross income versus net income, keep these additional things in mind:
- Gross income is always higher than net income for a company.
- Net income reflects profitability more accurately due to all expense considerations.
- Many companies intentionally showcase gross income over net income to appear more profitable.
- For capital-intensive industries indirect expenses are higher, creating a bigger gap between gross and net income.
- Income statement financial ratios calculate metrics based on both gross income (gross margin) and net income (net profit margin).
- Both income types play vital roles in financial statement analysis from different lenses.
In summary, gross income and net income both provide valuable metrics to assess a company’s earnings from different vantage points. Understanding the key differences between the two is essential for making sound business financial decisions based on accurate data.