Whether you're a business owner or a full-time employee, there are lots of figures you'll need to become familiar with to help you understand your tax forms, as well as your profits or salary. Two such figures are gross income and net income, closely related but different figures. Each can tell you different things about how a business operates, and can tell different stories about the success of that business.
What are gross and net income, what is the difference between them, and why should you care?
Gross Income vs. Net Income
Gross income is the revenue generated from a business's sales or an individual's labor. Net income is the profit made from that revenue when total expenses are taken out. For an individual, gross income is simply what your salary is while net income is what you actually take home in your paycheck.
Understanding the difference between the two is a helpful way to keep track of the income received from all of the combined ways an individual has money coming in, how well you're doing for income, and whether it would be wise to start saving money.
Each figure provides a different outlook for the party reporting its income. For a business, gross income can be a helpful way to view how well you generate revenue year in and year out, while net income lets you see how the expenses factor in. If your net income isn't where you want it to be, you can assess what expenses you may need to cut.
However, net income for individuals means less on official tax forms than it does for businesses. A person filling out their Form 1040 for the IRS will need to calculate a figure similar to net income - the adjusted gross income (AGI). Whereas net income takes taxes out along with deductible expenses, AGI simply deducts the expenses to show the amount of taxable income an individual has.
What Is Gross Income?
Gross income is the total amount of income earned over a period of time (often a fiscal quarter or a year). It is, essentially, how much the company makes on a product minus expenses directly related to creating the product. Other additional expenses are included in the figure (gross doesn't deduct those additional expenses, only COGS).
What this means, and what is and is not taken into account for gross income, will depend on a number of factors. It can mean something different for businesses compared with what it means for individuals, and when breaking it down even further, it can mean different things to different individuals.
Gross Income for Businesses: Gross Profits
Gross income can also be known as gross profits when being used to discuss the income of a business. Gross business income is the company's profit before expenses are deducted.
The equation used to calculate gross income for a business: Gross revenue - cost of goods sold = gross income.
As long as you have those first two figures you can calculate your company's gross profits. If revenue totaled $1,500,000 and the cost of goods sold (COGS) were $500,000, your business's gross income would be $1,000,000.
Taxes and various other expenses will not be subtracted for gross income, but a number of variables that make up the cost of goods sold will need to be deducted. COGS, for a business, is the combined cost of everything directly related to producing goods being sold by a company. This can include, among others:
- Raw materials
- Supply costs
- Equipment and machinery used to create product
- Packaging and shipping
- Labor costs for workers involved in direct manufacturing of product
Subtract these and any other cost directly related to the creation and sale of a product from the revenue, and you'll have your business' gross income.
Gross Income for Individuals
For individuals, calculating their own gross income can be much simpler. Their gross income is how much money they make before deductions, including taxes. If all you have is a full-time job, then your yearly salary pre-tax is your gross income.
Not everyone has a full-time salary, however, and not everyone who has one only has that as their source of income. Other forms of employment should also be factored into your gross income. If you own stock in a company that pays dividends to its shareholders, those dividends can be factored into your gross income. Interest you receive on money that has been invested in a savings account or rental property is part of it, as well as your pension.
If you sell items on eBay as a business, the amount of money you made in the sales of your items is your gross income for it.
What Is Net Income?
If gross income is what a business or individual makes, the net income is what their actual profit is. Additional expenses are now factored in, essentially making net income the money you are left with after everything that has to be deducted is deducted. If it is still a profit, it's net income. If the result of that is a negative amount, your net income is a loss.
Net Income for Businesses
Gross business income already deducts the COGS. To calculate the net goods, other expenses - including taxes - have to be deducted as well. Thus, the formula for calculating it: Total revenue - total expenses = net income.
Net income, in deducting other expenses, involves more than just the most direct expenses related to the product sold. Selling expenses, aka expenses required for the labor in selling your product, is taken into account. That includes salaries and benefits for employees at the business. Travel expenses are deducted from revenue, as are expenses related to the company's office. The money spent on advertising, marketing, events and client-related expenses is also deducted.
With all the expenses taken out, ideally one can get a better idea of how profitable their business is, and if the money they make selling their product is more than the money they spend on the business.
Let's return to the example used earlier. Their gross revenue was $1.5 million and their COGS was $500,000, leading to a gross income of $1 million. But now the remainder of the business's expenses have to be taken into account, and combined they total up to $400,000. That means their net income comes out to $600,000; significantly lower than the gross revenue, but still profitable.
Net Income for Individuals
Individuals don't have quite the same expenses required for deduction that businesses do, but for a single person's net income, there is still plenty to deduct.
Net income is where taxes are factored into a person's salary, as well as benefits that would be deducted from one's paycheck, such as healthcare premiums. If you contribute to a retirement plan or a flexible spending account for medical expenses, you can deduct those as well.