Gross Profit, Operating Profit and Net Income

The terms "profit" and "income" are often used interchangeably in day-to-day life. In corporate finance, however, these terms can have very different and specific meanings, depending on the context in which they are used.

While income does mean positive flow of cash into a business, net income is something much more complex. Profit is generally understood to refer to the cash that is left over after accounting for expenses. Though both gross profit and operating profit fit this definition in the simplest sense, the kinds of income and expenses that are accounted for differ in important ways.

Perhaps the simplest way to understand these three concepts – gross profit, operating profit and net income – and how they relate to each other is to look at them in the order they appear on a company's income statement. The top line of the income statement reflects a company's gross revenue, or the total amount of income generated by the sale of goods or services. From there, various expenses and alternate income streams are added and subtracted to arrive at different levels of profit.

Gross profit is the total revenue less only those expenses directly related to the production of goods for sale, called the cost of goods sold (COGS). These include expenses for raw materials and the labor to build or assemble a product but exclude other wages and overhead expenses, such as rent.

Gross profit = Revenue - Cost of Goods Sold

The result is a profit metric that reflects the amount of money left over to fund the business after accounting for the cost of simply producing a product. While gross profit is technically a net measurement of profit, it is referred to as gross because it does not take debts, taxes, interest or operating expenses into account.

Next on the income statement is operating profit. Derived from gross profit, operating profit reflects the residual income that remains after accounting for all the costs of doing business. In addition to COGS, this includes fixed-cost expenses such as rent and insurance, variable-cost expenses such as shipping and freight, payroll and utilities, as well as amortization and depreciation of assets. All the expenses that are necessary to keep the business running must be included.

Operating Profit = Operating Revenue - COGS - Operating Expenses - Depreciation and Amortization

However, like gross profit, operating profit does not account for the cost of interest payments on debts, additional income from investments or taxes. Gross profit reflects the profitability of a company's operations.

Finally, net income, also called net profit, is the infamous bottom line. This reflects the total residual income that remains after accounting for all cash flows, both positive and negative. From the operating profit figure is subtracted all debt expenses such as loan interest, taxes and one-time entries for unusual expenses such as lawsuits or equipment purchases. All additional income from secondary operations or investments and one-time payments for things such as the sale of assets are added.

The result is arguably the most important financial metric of them all, reflecting a company's ability to generate profit for owners and shareholders alike.