How to Calculate Net Sales?
Net sales are the total amount of revenue your business has after accounting for any sales returns, allowances, and discounts. The net sales figure can be found in your income statement. Net sales are vital information for understanding and making decisions for your business because they measure a company's actual revenue and financial health more accurately than gross sales.
Follow along below as we review what net sales are and how to calculate them. We'll also discuss how they affect the operations of your small business.
What Are Net Sales?
Net sales are what remain after all forms of sales deductions are subtracted from the gross revenue amount. Businesses that sell goods and products usually use the term "net sales," but you're more likely to see "net revenue" in your financial reports if you have a service-oriented business.
The formula for net sales is:
|− Sales Discounts|
We'll be discussing the details of the separate components below, but here's a simple example of calculating net sales: Suppose the owner of a small shoe shop has gross sales of $75,000, returns amounting to $1,600, allowances of $900, and discounts of $2,500.
Net sales are calculated and used as a basis for determining net profit because they accurately represent the amount of money the business generated from sales. In the example above, if a company doesn't account for sales adjustments like returns, allowances, and discounts, it's net profit will be overinflated by $5,000. This oversight can also result in an inaccurate calculation of the company's profit margins. Both outcomes are not helpful in understanding sales numbers or managing cash flow.
Profit margins are used by businesses to express how many cents are earned for every dollar of sale. To demonstrate how net sales are used to calculate profit margin, let's use the example above to compute the gross profit margin.
Let's assume the cost of goods sold (COGS) amounts to $21,000 and net sales equal $70,000.
|Gross profit margin|
From this example, we learn that the business retains 70 cents per dollar of sale after accounting for the direct costs of making the product. If we had used gross sales in the calculation, the number wouldn't have represented the company's actual profit margin.
What Is the Difference Between Net Sales and Gross Sales?
Gross sales are the total amount of revenue a business generates during a certain period. The figure represents how good a business's strategy is attracting and generating sales. However, it doesn't account for any returns or allowances on the products or services sold.
Net sales are the result of deducting returns, allowances, and discounts from gross sales. This figure is considered to be a more accurate measure of a business's revenue. It's also used for calculating profit margins and the net profit of the company.
Both numbers are equally important in understanding the overall financial health of your business. If your company's gross sales are increasing but your net sales are not, it may mean you're great at selling but you might be giving huge discounts. It could also signal that your products' quality is lagging and you're getting too many returns.
Net Sales Formula
In this section, we'll examine the line items needed to calculate net sales. We'll also walk you through the calculation in the following steps.
To calculate net sales, remember the formula:
|− Sales Returns|
|− Price Reductions/Discounts|
Step 1: Determine Gross Sales
Gross sales is the total revenue your business earned during a specific period — weekly, monthly, quarterly, or yearly. This amount includes all cash purchases plus all orders paid for by credit card, debit card, or gift cards. To determine gross revenue, total all sales without adjusting for any discounts, sales allowances, or returns.
If you use the cash method of accounting for your business, gross sales will only include the sales for which you've received payment. If you subscribe to the accrual accounting method, though, your gross sales account for all orders you've completed and delivered, including those that haven't been paid for yet.
Step 2: Calculate Sales Returns
Sales returns account for any goods bought but consequently returned by customers. To calculate, add everything your business refunded for the specific accounting period you're trying to track. This applies whether you gave a partial or full refund for an item or service.
Step 3: Total Sales Allowances
Allowances are discounts that businesses give customers for any number of reasons. The product may have been damaged during transport, but the customer is still willing to keep it. In this instance, the business owner offers a discount to account for the damage.
An example of an allowance would be if a customer paid $2,500 in defective products and you gave them a $500 discount. You would then record and use the $500 to reduce your gross sales at the end of the financial reporting period.
Step 4: Account for Price Reductions
Businesses, especially retail companies, have many reasons to offer discounts. These reasons may include facilitating a fast sale or rewarding customers for early payments. Some businesses also reduce their products' prices to sell old stock or seasonal goods and merchandise.
Calculate your total discount amount by adding all sales price reductions you've given to customers for a specific period of time. It might be easy to track discounts to bulk purchases since there may not be a lot. However, you may need to have a system that tracks all of your deals, returns, and allowances if you have a high number of sales transactions with smaller amounts.
Step 5: Calculate Net Sales
Now that we've learned the separate line items that comprise your net sales calculation and how to find them, we can proceed with another example. This time, we'll calculate the net sales for a business owner with a stationery store that makes custom cards and made-to-order wedding invitations.
Let's assume the following amounts:
- Gross sales: $55,000
- Returns: $500
- Allowances: $500
- Discounts: $1,500
Here's the formula again:
|− Sales Returns|
How Do You Find Net Sales on an Income Statement?
Your income statement shows how much income you make on your business and how it's spent or allocated. The cost of sales is shown on the income statement and divided into three categories: direct costs, indirect costs, and capital expenditures. Net sales are reported on the income statement as the starting figure on the direct costs portion.
Direct costs are expenses like commissions, direct labor, and materials that can be traced to the production and selling of specific goods or services. Indirect costs include supplies, utilities, and office equipment rentals. Meanwhile, capital expenditures are purchases of major physical goods or services that the company will use for more than a year, such as land, vehicles, and machinery.
Net Income Statement
January 31, 2021
If a company's income statement only reports one line item of "Sales", the amount is interpreted as net sales. The user assumes that discounts, returns, and allowances (if any) have been accounted for.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for specific advice regarding your small business finances.