What is the difference between gross profit and net profit?

Production is possible by the united efforts of four factors of production viz. land, labour, capital and organization. The whole of income or total revenue earned by firm is divided among four factors of production. After distributing the revenue among three factors of production, what remains goes to the share of an entrepreneur. This residual revenue thus firms profit of an entrepreneur. Thus profit is a residual income.

The share of income received by an entrepreneur in the process of distribution is called profit. Therefore, profit is the excess of income from the sale of production over his cost of production. As an entrepreneur takes vital decision in production, makes co-ordination among factors of production and bears all risks, uncertainty, he deserves profit.

J.B. Clarks opines that profit arises because of the changes that frequently occur in the economy. To Schumpeter profit is a reward for an entrepreneur’s introducing innovation. F.H. Knight has emphasized the role of uncertainty in giving rise to profits. As entrepreneur takes all the hardship of production, he therefore deserves profit. In production, profit is, thus, the difference between total revenue and total cost of production.

Therefore Profit = Total revenue — (Rent + Wages + Interest)

Gross Profit:

The difference between the total revenue and total cost is called Gross profit. Gross profit arises after deducting all expenses of production from the total income. Thus it is the excess of total income over total cost of production. To produce, output, the firm or entrepreneur has to hire and pay for labour, raw materials, powers, rent for land, Interest on borrowed capital and meet depreciation changes.

After selling there output a firm get certain revenue from the sale of its products. The excess of the revenue earned over these various payments and charges is called gross profit.

Gross profit consists of various elements. In other words there are various components of gross profits which have been given below.

(i) Wages of Management:

The entrepreneur performs the task of management, and supervision. But his remuneration for the above tasks is not deducted from the Gross Profit. If he had done the above task else where he would have received certain rewards. Thus from gross profit his remuneration for management must be deducted. Thus the element of wages of management is a part of the gross profit.

(ii) Rent on entrepreneur’s own land:

Gross profit also includes rent that arises from the entrepreneur’s own land used in his production of output. The entrepreneur in his production uses his own land, factory building, worker’s sheds etc. which he could have given to other producers in return of rent. Thus the rent arising out of his own land and building is to be subtracted from the gross profit to arrive at net profit.

(iii) Interest on his own Capital:

The entrepreneur has also got his own capital which he invests in the production of output. He never takes interest from the employment of his capital. His gross profit, therefore, includes the interest on capital provided by the entrepreneur. His personal capital could have fetched him some income if they had been provided to other’s production activity. Thus interest on his capital must be deducted from the gross profit.

(iv) If the entrepreneur earns excess profit on account of certain advantages of monopoly the excess or super normal profit subtracted from the gross interest. Because this profit se of market advantage not because of his effort. Thus income calculate net profit his monopoly profit must be sub’ id from the gross profit.

(v) Sometimes profit arises due to certain chance factors, is profits arise unexpectedly. These profits are caused by chance not by human effort. Thus the amount of profit arising out of such source is to be deducted from the gross profit.

Net Profit:

Net Profits arise because of function of a person as an entrepreneur. These functions are risk bearing ability, introduction ovation etc. Thus net profit is the excess of revenue over it and implicit cost of production. After deducting all explicit costs from the gross profit, the residue forms the net profit. Profit may be negative or positive. Net profits’ include five components which are explained below.

(i) Payment for risk and uncertainty:

Every business involves some amount of risks and uncertainty. An entrepreneur takes risks in the business. The business may flourish or may be liquidated due to widespread loss. Demand for the product may decline overnight. This may lead to a severe fall in sale of output. Thus business uncertainty and risks are borne by an entrepreneur. Thus he is rewarded for risk bearing. This reward is included in net profits.

(ii) Reward for bargaining ability:

The reward arising out of bargaining ability of an entrepreneur is also included in the net profit. The entrepreneurs having good bargaining power can employ cheaper factors of production and there by reduce their cost of production. So they earn more revenue and hence more profit.

(iii) Reward of Innovation:

Innovation means introducing new method of production in production. By introducing newly invented techniques in production, an entrepreneur reap wide spread profit than others. The reward for having introduced innovation in the production is included in the net profit.

(iv) Monopoly gains:

Monopoly gains arise due to the nature of market. In such a market condition the entrepreneur can pay lower prices to the hired factors. He can charge higher price of his product as he enjoys the exclusive power of producing that brand of output. In monopoly, the profit is definitely higher. We also exclude such monopoly gains from gross profit.

(v) Chance gains

Profit may arise due to certain chance factors. In such a case no amount of an entrepreneur’s effort has been made to reap such profit. Due to sudden rise in demand for a commodity will raise the price thereby giving rise to windfall profit. This type of profit is not included in net profit. Thus in order to arrive at net profit this windfall gain is to be subtracted from gross profit.