Gross income is a way of measuring the profit generated from sales alone, using just your total revenue minus the cost to you for the goods you sold. Net income, though, goes a few steps further by putting those profits in the context of your entire operation, measuring what’s actually left after accounting for the various other expenses associated with running your business. This basic principle is usually applied to corporate accounting, but the fundamental differences between gross and net income can be applied to personal finance in a way that can help you budget and plan even if you’re not a business owner.
What Is Gross Income and What Is Net Income?
Say you’re running a Jet Ski dealership and you sell 25 Jet Skis over the course of the year for $10,000 apiece. If your wholesale price for those Jet Ski was $5,000, your gross income for each watercraft would be $5,000, making your gross profit on the year $125,000.
But anyone who operates a business can probably tell you that it’s never that simple. Your might owe $20,000 a year to rent your beachside storefront, another $15,000 for the ad campaign that got most of your customers in the door and then the $35,000 salary for your salesman Phil, who also pockets a $1,000 commission for every Jet Ski sold. All told, that’s $95,000 in money paid out for stuff that made the sale of those 25 Jet Skis possible.
So, although that $125,000 gross profit is certainly good to know and can play an important role in your forward planning, the reality is that you’re certainly not just pocketing $125,000. Your net profits are $30,000 after accounting for rent, marketing and Phil.
How to Calculate Net Income
Based on the definition of “net income,” you calculate it by looking at your total revenue and subtracting any and all expenses. Gross profit just takes your total revenue (all the money coming in) and subtracts just the costs of acquiring the goods or services you sold — either the price you pay for them or the cost of making them. But in net income, you’re including all of those additional costs beyond just acquiring the goods that you sell. Although that example is kept simple, real businesses — and especially large corporations — will have a variety of additional costs that might include (but aren’t limited to) taxes, depreciation of assets, research and development, administrative expenses, operating expenses and interest on loans.
For your personal finances, they’re typically a lot simpler for a salaried employee: Your gross pay is what you’re getting in total, but your net pay is what you’re actually getting in your bank account after taxes are withheld from your paycheck. However, if you’re a business owner or independent contractor, your net pay will involve calculating all of the expenses included in performing your job.
Why Net Income Matters in Business
Examining the differences between gross and net income can be an important method for examining potential stock investments. A company’s ability to limit expenses and convert the gross profits from their business into net profits is a crucial factor to their long-term value as a company.
However, it’s not as simple as just picking stocks with high net profits. Plenty of fast-growing companies will show low or negative net profits while they spend lavishly on company growth and improving their core business. However, that doesn’t mean they can’t ultimately shift gears and generate massive net profits when the time is right.
Say you start spending $25,000 a year to build out and advertise your new website where customers can make online purchases. Your net income would drop to $5,000 a year, making your business look fairly weak on paper. But if your website slowly grows in popularity until you’re selling twice as many Jet Skis after a few years — additional sales in which you don’t owe Phil his $1,000 commission — it becomes clearer that eschewing net income in favor of more growth was a wise choice.
Likewise, great net profits are rarely a bad sign, but a company that’s overly focused on maximizing its bottom line without thinking bigger could be in for trouble. If you decide your net income isn’t high enough and then cut your advertising budget entirely, you might have a few years during which you’re looking at another $15,000 in net income and thinking you’re a master businessperson. But, if eliminating your advertising budget means you stop attracting new business and your annual sales fall from 25 to 20 to 15 Jet Skis over time, that temporary boost to your net income will be erased.
In each case, an investor examining the businesses with no consideration other than net income might come away making the wrong call about the long-term prospects and cost the company money. So, although net income is a key factor to consider when examining potential investments, it’s also important to keep it in the broader context of the complete business.
Applying Gross vs. Net Income to Your Personal Finances
Even if you’re not a business owner, the basic principle of comparing gross income with net income can still be important with your personal finances, especially when it comes to budgeting.
Planning your budget based around your gross income is going to create issues as your net income after taxes is usually going to be about 20 percent lower. Although your gross pay might be $50,000 a year, your net pay is likely going to be more like $37,000, depending on where you live. So if you’re trying to apply the basic 50-30-20 budgeting rule to your income but starting with $50,000 as your baseline, the reality of what’s actually coming in with each paycheck is going to be very different than what’s in your budget.
What’s more, you might apply the concept when comparing the compensation packages from different jobs. If one job is offering you a little more money but doesn’t offer health insurance, you should take the time to calculate what your net income would be after factoring in the value of your benefits. If your net pay with that job is actually lower after factoring in the cost of obtaining your own health insurance, you can see how the higher gross income might not be worth it.
More on Income and Wealth
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