Gross income is the difference between net sales and the cost of goods sold. To arrive at this figure, you must first calculate net sales, which equals gross sales minus returned merchandise. Then subtract the direct cost of all goods sold or services delivered from net sales to find gross income. The cost of goods sold must not include any expenditures not directly related and proportional to manufacturing the goods or preparing the services delivered. An additional metric, which is highly helpful for the analyst, is the gross income ratio--also known as gross profit ratio--calculated by dividing gross income by net sales and multiplying the result by 100.
Significance of Gross Income
The relation between gross income and net sales, which is best captured by the gross income ratio, tells the analyst if the proportion of sales price to manufacturing cost is appropriate. An insufficient gross income ratio may be a sign that the firm is cutting prices too aggressively in an effort to improve total sales. Another possible explanation is that the sales price is right but the cost of manufacturing is too high, once again leaving the firm with unsatisfactory gross income levels. It's impossible to determine which of these explanations applies, or if both apply to some extent, without a closer look at selling prices and manufacturing costs.
Net Income is the amount of money the firm makes after accounting for all expenses incurred while running the business. To calculate this figure, start with gross income and subtract all expenses that haven't been accounted for while calculating the cost of goods sold. Expenses may include rent, salaries, fees, and expenses that aren't directly related to production levels, such as registration fees with legal bodies, interest expenses on loans, and taxes. The resulting figure is the amount of income the firm has generated at the end of the year. This number doesn't necessarily correspond to an increase in the firm's cash position, however. A corporation can generate a great deal of income yet have no cash on hand if it invests the money back into the business.
Importance of Net Income
Net income is a more critical figure than gross income, as it represents how much money the firm has made for shareholders. If the gross income figure is satisfactory but net income is less than desired, the problem generally lies with overhead expenses and financing costs. The firm may be paying too much for personnel and facilities that aren't directly involved in production, or the interest charges on its loans may be excessive. The solution lies in running a leaner operation with minimal overhead expenses, borrowing less money, or borrowing funds at lower interest rates.