“We have more orders and everyone is busier, but the month-end accounts show lower earnings.” Higher revenue does not necessarily mean a more profitable business. Start by understanding the difference between gross and net profit, then compare the gross profit from extra sales with the additional expenses.
This simplified retail example explains gross profit, gross margin, net profit and net margin, and why a 20% revenue increase can coincide with an almost sixty percent drop in net profit.
What Is the Difference Between Gross and Net Profit?
Gross profit is revenue less cost of sales; net profit is the result after operating expenses, interest, tax and other applicable gains or losses. Here, net profit means profit after tax, rather than the bank balance or cash available for the owner to withdraw.
| Measure | Simplified calculation | What does it show? |
|---|---|---|
| Gross profit | Revenue − Cost of sales | The amount remaining after the corresponding sales costs |
| Gross margin | Gross profit ÷ Revenue × 100% | Gross profit retained from every 100 dollars of revenue |
| Net profit after tax | Gross profit − Operating expenses − Interest expense − Income tax expense | Profit after expenses and tax |
| Net margin | Net profit ÷ Revenue × 100% | After-tax profit retained from every 100 dollars of revenue |
The net profit formula assumes no other income, gains or losses, and the ratios require non-zero revenue. Revenue here is net of sales returns and discounts.
Gross Profit: What Remains After Selling an Item?
An item sold for 100 dollars with a cost of sales of 60 dollars generates gross profit of 40 dollars and a 40% gross margin. Administration and promotion costs may still need to be deducted, so those 40 dollars are not final net profit. For where gross and net profit appear in the income statement, see the SEC’s Beginners’ Guide to Financial Statements.
Cost of sales depends on the business. Retail generally includes the cost of goods sold; manufacturing inventory also includes direct production labour and appropriately allocated manufacturing overheads. Therefore, not all payroll or rent should automatically be classified as operating expenses below gross profit, and all inventory purchased but not sold in a month should not automatically become that month’s cost of sales. For recognition when inventory is sold, see the IFRS Foundation’s IAS 2 overview.
Net Profit: What Remains After Other Expenses?
Higher gross profit means more remains after cost of sales. Net profit can still decline if advertising, administration or other expenses rise faster. Distinguish operating profit, profit before tax and profit after tax, and use consistent classifications and calculations when comparing months.
Why Can Revenue Rise 20% While Net Profit Falls Almost Sixty Percent?
Suppose a retailer has the following results for the previous and current months, using consistent classifications and with no other income or gains and losses. All amounts are hypothetical and expressed in Hong Kong dollars. Shop rent is simplified as an operating expense here; this is not a universal classification for every business.
| Item | Previous month | Current month |
|---|---|---|
| Revenue | 300,000 | 360,000 |
| Cost of sales | 180,000 | 234,000 |
| Gross profit | 120,000 | 126,000 |
| Gross margin | 40.00% | 35.00% |
| Shop rent (simplified treatment) | 24,000 | 24,000 |
| Administration and sales staff | 40,000 | 44,000 |
| Advertising and promotion | 18,000 | 30,000 |
| Other operating expenses | 10,000 | 14,000 |
| Total operating expenses | 92,000 | 112,000 |
| Operating profit | 28,000 | 14,000 |
| Interest expense | 2,000 | 3,000 |
| Profit before tax | 26,000 | 11,000 |
| Income tax expense (assumed) | 4,000 | 2,000 |
| Net profit after tax | 22,000 | 9,000 |
| Net margin | 7.33% | 2.50% |
The assumed income tax expense illustrates the calculation. It is not derived from Hong Kong or another jurisdiction’s statutory rates and does not represent actual tax paid that month.
Revenue increased by 60,000 dollars, but cost of sales rose by 54,000 dollars, leaving only 6,000 dollars of additional gross profit. Gross margin fell from 40% to 35%, a decline of 5 percentage points.
Meanwhile, operating expenses increased by 20,000 dollars, exceeding the extra gross profit. After changes in interest and tax, net profit fell from 22,000 dollars to 9,000 dollars, a decrease of 13,000 dollars, or approximately 59.1%.
Breaking down the change makes the reason clear:
Additional gross profit of 6,000 − Additional operating expenses of 20,000 − Additional interest of 1,000 + Reduction in tax expense of 2,000 = Net profit decrease of 13,000 dollars.
Busier but Less Profitable? Check These Four Areas
1. Discounts Reduce Profit per Order
At a selling price of 100 dollars and cost of 60 dollars, gross profit is 40 dollars. After discounting the price to 90 dollars with unchanged cost, gross profit is only 30 dollars. The price falls 10%, but unit gross profit falls 25%. With unchanged costs and product mix, volume must rise about 33.3% to maintain total gross profit, before extra advertising or staffing costs.
2. Lower-Margin Products Account for More Sales
Even if individual prices and costs are unchanged, overall margin can fall when lower-margin products form a larger share of revenue. Analyse key products, services or channels rather than relying only on the company average.
3. Costs and Expenses Rise with Sales
Purchase prices, production labour, wastage, advertising, platform fees and overtime can affect profit, but should be classified according to their nature. Include relevant cost of sales and extra expenses when assessing campaigns, and avoid deducting the same expense twice.
4. Impairment or Additional Expenses Arise
Inventory write-downs, receivable impairments or extra repairs may reduce monthly profit. Investigate the amount, reason and likelihood of recurrence; an infrequent item should not automatically be excluded or labelled one-off. Inventory impairment may also affect gross profit, depending on presentation.
How Does Net Profit Differ from Cash Flow?
Revenue that meets recognition criteria is not automatically reversed simply because the customer has not paid. However, receivables at risk of impairment require assessment and recognition of losses under the applicable standards.
Buying unsold inventory or equipment, or repaying loan principal, may reduce cash without the full payment immediately becoming an expense. Review the income statement, receivables and cash flow together. The official IAS 7 overview also distinguishes operating, investing and financing cash flows.
A Useful Order for Monthly Financial Reviews
- Compare revenue and gross margin: Use consistent periods and classifications; seasonal businesses should also compare the same period last year.
- Break down products and channels: Identify changes in prices, costs and sales mix.
- Compare additional gross profit with additional expenses: Determine how much profit the extra business actually retains.
- Reconcile net profit and cash receipts: Review changes in receivables, impairments, inventory and bank balances.
When sales next rise, compare the extra gross profit and expenses in one table before increasing advertising or staff. If current classifications obscure costs, organise sales, purchases, payroll and bank records, then contact M&N to discuss suitable Accounting and Bookkeeping Services.
Gross and Net Profit FAQs
Does a 40% Gross Margin Mean Adding Forty Percent to Cost?
No. With cost of 60 dollars and a selling price of 100 dollars, gross margin is 40 ÷ 100 = 40%, while markup on cost is 40 ÷ 60 ≈ 66.7%. The denominators differ, so do not confuse them when pricing.
Can a Business Have Gross Profit but Still Make a Loss?
Yes. If gross profit does not cover other expenses and applicable gains or losses, the business may record a net loss. There is no universal acceptable margin for every industry; consider the business model, expense structure and historical performance.
Is Net Profit Simply the Increase in the Company Bank Balance?
No. Collection and payment timing, asset purchases and loan principal transactions make cash movements differ from profit. Use the income statement to assess profitability, and cash flow and upcoming payments to assess short-term payment capacity.
Sources
- SEC：Beginners’ Guide to Financial Statement(Financial statement fundamentals)
- IFRS Foundation：IAS 2 Inventories(Inventory cost, expense recognition and impairment)
- IFRS Foundation：IAS 7 Statement of Cash Flows(Profit and loss versus cash flow)
- IFRS Foundation：IFRS 9 Financial Instruments(Impairment of financial assets)
Information review date stated in the article: 7 October 2026. Simplified examples explain general financial concepts, not accounting or tax advice for an individual company. Classification, recognition and presentation depend on the business and applicable accounting standards.
