What Is the Difference Between Net and Gross Income?

Strategic planning and tax-related decisions are two examples of the many business scenarios where a firm understanding of net vs. gross income can have far-reaching effects. Here we break down the key differences between these two terms, both of which are vital indicators of the health of a business.

Financial reporting can be complex, but knowing the types of income can help assess a company's performance. Whether your small business prepares an income statement once a year or once a quarter, the computed net and gross income are two numbers that often provide important information about company performance and overall management.

A profit-and-loss statement reports the differences between gross vs. net income. When prepared in a standard format, the income statement is a useful tool for comparative analysis against prior time periods or other industry players. A proper analysis of revenues or gross income and the bottom-line net income can assist with effective strategic planning and tax-related decisions.

What Is Gross Income?

Gross income is the total amount earned by a business, less the cost of producing the goods sold. The calculation of gross income starts by adding all revenues, which is the total sales and other income a business receives, including cash, check and credit card sales and dividends, rental income, and canceled debt. To calculate the gross income, all direct costs of producing the item are subtracted, such as manufacturing costs. These costs are referred to as the cost of goods sold. Sales and marketing costs, administrative expenses, and taxes are not included in the calculation of gross income.

Gross Pay, Gross Profit, and Gross Income: What Are the Differences?

In general, when looking at gross income amounts for a business, the number in question is prior to certain expense deductions. The terms gross income, gross profit, and gross pay may be used interchangeably, so it helps to ask detailed questions to determine the proper calculation.

When discussing a business outside of the manufacturing industry that does not generally report a cost of goods sold, gross income may also be referred to as gross profit. Gross profit may also be used when describing total revenues. A gross income amount is reported on a company's profit-or-loss statement and is typically a standardized calculation for businesses in the same industry.

Gross pay is the term used when referring to an individual's salary or hourly rate reported on a paycheck, before payroll deductions for benefits and taxes. Gross pay can also be reported as an annual amount.

What Is Net Income?

Net income is the bottom-line profit generated by a business. It is gross income minus all business expenses, which can include the cost of goods sold, and also advertising, rent, utilities, or wages. Depending on the industry, a business expense can be a cost that is common or accepted in the field, or an expense that is specifically helpful or appropriate in a trade or business.

Some other common business expenses include:

• Auto expenses
• Entertaining clients
• Trade shows, conventions, and seminars
• Membership fees for professional associations
• Local business taxes and fees

In addition to revenue factors, net income also takes into account how well expenses are managed. Tax programs offered by the government may assist with increasing net income. For example, local and state tax levels vary, so choosing to locate a business in a certain area could result in a lower tax expense. The IRS also offers many tax credits to qualifying small businesses, including a credit for the production of renewable energy and a credit for companies providing child-care facilities and services.

Net Pay and Net Income: Are They the Same?

Net income may be referred to as net pay, especially when speaking about an individual's salary. At a basic level, net income is the term used to describe a bottom-line number, after all required amounts have been deducted. When calculating net pay, the amount is typically the actual amount of a paycheck, after payroll tax and other deductions such as health insurance premiums or retirement savings account contributions. Net income is the amount left after subtracting all expenses — which may also be described as the "net profit" for a business.

Differences Between Gross vs. Net Income

The Relationship Between Income and Cash Flow

An analysis of the different types of income should also include an evaluation of cash flow. Income may be reported on a profit-or-loss statement, but if cash or liquid assets are not available to support operations, the company may struggle to cover expenses. A cash flow statement can be prepared to track influx and outflow of cash and provide assurance that sales revenue was collected on a timely basis. Proper cash flow management helps avoid shortfalls created by seasonal sales slumps. For instance, a company selling holiday-themed merchandise may find that a majority of its revenues are earned in one quarter of the year. However, the business still must maintain enough cash on hand to fund year-round operations. Or, a company might report $1,000 in sales on the income statement, though customers only reimburse them for half that amount upfront. Until the balance due is collected, the addition to cash flow will be less than the income reported on the income statement. Using just the income statement for analysis paints an inaccurate picture of the company's overall finances.

Why Do Differences Between Net and Gross Income Matter to Your Business?

Gross and net income are useful tools for business decisions. Gross income numbers indicate the health of revenue streams. Business revenue reported as gross income can be broken down by product to determine success.

Net income shows the amount of profit generated, taking all expenses into account. If gross income remains at an expected level, but net income starts to dip, a business can make adjustments by searching for ways to lower certain expenses. If expenses are higher than income, the company will report a net loss.

You may also want to use the individual components of gross and net income calculations to determine what level of production will allow you to break even and how much business you'll need to generate each month or year to earn a profit.

Net income is also important because it's the number used by the IRS to determine the amount of business taxes owed. Depending on a business structure, net income may be taxed differently. Sole proprietorships and limited liability companies (LLCs) report their net income on the business owner's personal tax returns. S corporations pass through their income to shareholders, who are then taxed at their individual tax rates. C corporations file separate returns and calculate their tax liability as a separate entity, apart from shareholders. A tax or legal advisor can help determine the best business structure for tax reporting purposes.

Income vs. Cash Flow as a Strategic Opportunity

Calculating net income offers businesses the opportunity to review both revenue and costs line-by-line, and answer strategic questions like: Are there areas and opportunities to grow? What are the biggest costs?

With a strong understanding of net income, a business owner can begin to test general assumptions and make decisions based on unique data. It could result in decisions to raise prices, for example, or cut expenses. It varies depending on business and industry, but in general, strategy decisions should be made after a careful analysis of the income statement.

When reviewing your company's gross and net income, inevitably cash flow management will also come into play. A firm understanding of the specific profitability metrics used in your industry, such as profit margins, Return on Assets (ROA) or Return on Investment (ROI) will help you gain insight into how you're earning money and if you're spending efficiently. Explore more resources on WORX.