Evrenus Fırat Polat · ·
"We made a profit" can mean two very different things depending on which number you're looking at. Confusing gross profit with net profit is one of the most common, and most consequential, mistakes in small-business pricing.
Gross profit: revenue minus the direct cost of what you sold
Gross profit is revenue minus the direct cost of producing what you sold: materials, direct labor, whatever was spent specifically to deliver that product or service. It answers: for every sale, how much is left after covering what it actually cost to make or deliver it?
Gross margin is gross profit as a percentage of revenue: (Revenue − Direct costs) ÷ Revenue × 100.
Net profit: what's left after literally everything
Net profit takes gross profit and subtracts everything else: rent, insurance, software subscriptions, administrative time, marketing, interest, taxes. It answers a much bigger question: after running the entire business for this period, is there actually anything left over?
Net margin is net profit divided by revenue.
Between the two sit other measures, like operating profit (gross profit minus operating expenses, before interest and tax). For a small business, the key split is simply "direct costs only" versus "everything."
Why the difference matters for pricing
A healthy gross profit margin can hide an unhealthy net profit margin. A product with a strong 60% gross margin can still leave the business unprofitable overall if fixed costs (rent, salaries, everything not tied to a specific sale) outweigh what all that gross profit adds up to across the whole business. Pricing decisions made only by looking at gross profit risk setting prices that feel profitable per sale while the business as a whole loses money.
A concrete example
Sell a service for $1,000 where direct costs (materials, contractor labor) are $400: gross profit is $600, a 60% margin. That looks healthy in isolation. But if the business's fixed costs (office, software, your own admin time, insurance) run $500 per similar job on average, net profit on that same sale is only $100, a 10% margin. Both numbers are correct. They're just answering different questions.
Worked example: a full year
A freelance design studio has these figures for the year:
- Revenue: $150,000
- Direct costs (contractors, stock assets, print costs): $45,000
- Rent and utilities: $18,000
- Software and equipment: $9,000
- Marketing: $6,000
- Insurance and accountant: $5,000
- Interest on a loan: $2,000
- Income tax: $12,000
Step 1, gross profit: $150,000 − $45,000 = $105,000. Gross margin: 105,000 ÷ 150,000 = 70%.
Step 2, operating expenses: $18,000 + $9,000 + $6,000 + $5,000 = $38,000.
Step 3, operating profit: $105,000 − $38,000 = $67,000.
Step 4, net profit: $67,000 − $2,000 interest − $12,000 tax = $53,000. Net margin: 53,000 ÷ 150,000 = 35.3%.
If you tracked only gross margin, you would think you keep 70 cents of each dollar. You actually keep about 35 cents. Note that for sole traders in many countries, the owner's own pay is not a separate expense, so the "net profit" is also what the owner lives on. Treatment of owner pay, depreciation and tax differs by country and legal structure, so ask your accountant.
Step by step: using both numbers to price
- Add up your direct costs for a typical job.
- Add your yearly fixed costs, divided by your expected number of jobs or billable hours, to get an overhead share per job.
- Add the profit you want.
- The sum is the price. Check the gross margin and the expected net margin.
- Compare the price with the market and adjust scope, not only price.
- Review your actual net profit each quarter against the plan.
Our margin calculator and markup calculator work at the gross-profit level, which is useful for pricing individual jobs. For hourly work, our freelance rate calculator helps you set a rate that covers overhead too. More on this in pricing your services.
Common mistakes
- Mixing up margin and markup. A 50% markup on cost gives a 33% margin, not 50%.
- Calling all costs "direct." Only costs that vary with each sale belong in gross profit.
- Ignoring your own time. If you do admin unpaid, your real hourly rate is lower than you think.
- Forgetting tax. Profit before tax is not what you can spend.
- Comparing against profit on paper. Cash may differ from profit. See cash flow basics.
Use both, for different decisions
Gross profit is useful for comparing the profitability of individual products or services against each other: which one is worth doing more of. Net profit is what tells you whether the business as a whole is actually making money. Check your per-job numbers against your actual net numbers periodically to make sure per-job profitability is translating into a genuinely profitable business. Learn to read the underlying statements in reading financial statements.
FAQ
What is a good gross margin?
It varies hugely. Software and consulting often have gross margins of 70% or more. Retail and construction are often much lower. Compare with similar businesses.
Is operating profit the same as net profit?
No. Operating profit is before interest and tax. Net profit is after both.
Which one should I use to set my prices?
Use gross margin to price individual jobs, but make sure the gross profit is large enough to cover overhead and leave a net profit.
Are labor costs direct or indirect?
Labor that you can tie to a specific job (a contractor you hired for it) is direct. General admin or management time is overhead. Your accountant can help you classify costs consistently.