In this article, you will learn:
The profit and loss statement of your business measures Net Sales and expenses during a specific accounting period. Accordingly, it measures the net profit of your business. The Net Profit is the difference between your sources of revenue and expenses related to such revenue.
Your income statement showcases the financial progress of your business during a specific period. Furthermore, the profit and loss statement consists of the unchanging sales and expenses categories. These categories include Net Sales, Cost of Goods Sold, Gross Margin, Selling and Administrative Expenses, and Net Profit.
In this article, we are going to discuss what is net sales, how to calculate net sales, and review the net sales formula.
What is Net Sales?
Net Sales refers to your company’s total sales during an accounting period less any allowances, sales returns, and trade discounts. Furthermore, Net Sales are primarily indicated in the income statement of your business. This financial metric is used to analyse your business’s revenue, growth, and operational expenses.
Now, let’s consider the sales return component of the Net Sales. Different types of businesses allow for varying amounts for sales return. For instance, a manufacturing unit would have more sales return relative to a small retail store.
Then, consider the trade discounts. The amount allowed for trade discounts indicates the disparity between the standard price and the actual price that consumers pay you. Remember, the trade discount allowance reduces your total sales to represent the actual price that your consumers pay.
In addition to this, the manner and the time at which sales are recorded depends on your accounting and bookkeeping system.
How to Calculate Net Sales?
The Net Sales of your business are typically reported in the income statement. Your income statement showcases the total expenses of your business in the form of three different categories. These include direct expenses, indirect expenses, and capital expenses.
Thus, your net sales are represented in the section of the income statement where all the direct expenses are indicated. Furthermore, each business may not have to necessarily represent Net Sales in its income statement. This is because the components to calculate Net Sales do not apply to every business or industry.
So, Net Sales is calculated by subtracting the following components from the Gross Revenue of your business.
- Sales Return Allowances or Discounts
Sales Returns are the product items that buyers return to you as a seller to take a full refund of such goods. Such goods are returned on account of various reasons.
These include defective goods, excess quantity shipped, wrong items shipped, incorrect product specifications, etc.
Further, these goods must be returned within a few days immediately after they are sold. Thus, goods returned are either recorded as Sales Return. Or are directly deducted from sales revenue.
Thus, the following two accounts get impacted. An increase in sales and allowances account and a decrease in cash or accounts receivable. In other words, your sales return account gets debited and the cash or accounts receivable account gets credited.
Allowances are the grants you give to your customers. Such grants are given when your customers agree to keep the merchandise at a price lower than the original selling price. You as a seller have to provide such grants on account of the inferior quality, or wrong goods sent to the customers.
Thus, you record sales allowance as a deduction from gross sales. In other words, the sales return and allowances account gets debited. And an asset account gets credited. This results in a reduction in your gross revenue.
You must note that sales allowance is created once you bill your consumers. But, before the customer pays the amount to you as a seller. However, sales allowances are different from write-offs.
A write-off is recorded before you sell the goods to customers. It is an expense that lowers your asset value on account of any losses or damages to the asset.
As a seller, you may offer discounts to your customers in cases where you invoice them. This is done to encourage your customers to make payments early. Different businesses work on different discount terms with their customers. For instance, you may work on a discount term of 2/15 net 30.
Such a discount term means that you offer a 2% discount to your customers. Only if they make payment within 15 days of a 30 day invoice period. Remember, you do not account for discounts as a seller unless your customer makes early payments. Usually, you as a seller offer a sales discount when you are in need of cash or you want to reduce your accounts receivable for other reasons. Therefore, the discount would reduce your gross revenue and credit the assets account.
Let's look at an example. The following table showcases the gross sales and other details like allowances and discounts of Schwarz Enterprises.
|Particulars||Amount (in Dollar)|
|Gross Sales (1,000,000 unit x $3)||3,000,000|
Net Sales = Gross Sales – Sales Return – Sales Allowances – Discount
= $3,000,000 – $25,000 – $10,000 – $20,000
Gross Sales Vs Net Sales
|S.No.||Basis||Gross Sales||Net Sales|
|1.||Definition||Gross sales are the total sales transactions that your business makes within a specific period of time. You record such sales transactions without adjusting for discounts, allowances, sales returns.||Net sales is the total revenue less cost of sales return, allowances, and discounts.|
|2.||Formula||Gross Sales is equal to the total of all sales receipts before discounts, returns, and allowances. That is, the number of units sold multiplied by the price per unit.||Net sales are equal to gross sales less sales return, less allowances, less discounts.|
|3.||Purpose||Gross sale is a good measure to know the speed at which your business is generating sales||Net sales indicate a reduction in sales due to challenges like product quality, large marketing discounts, etc.|
|4.||Decision-Making||Gross sales is not a good measure to undertake decision making.||Net sales is a good measure to understand the financial position of your business and to undertake various decisions.|
|5.||Value or amount||The value of gross sales is higher or equal to the net sales of your business.||The value of net sales is always less than or equal to the gross sales of your business.|
|6.||Dependency||Gross sales are independent of net sales. That is, to calculate gross sales, net sales are not required.||Net sales are dependent on gross sales. This is because net sales are calculated after deducting the sum of sales return, discounts, and allowances from gross sales.|
|7.||Reporting in Income Statement||The value of gross sales is not reported on the income statement of your business. Rather, such sales are indicated in the financial statement notes section.||The value of net sales is reported in the net income statement of your business.|
|8.||Example||As mentioned above, gross sales of Schwarz enterprises would be 1,000,000 units x $3 = 3,000,000||As mentioned above, net sales of Schwarz enterprises would be $3,000,000 – $25,000 – $10,000 – $20,000 = 2,945,000|
How to Calculate Net Sales Revenue?
Your business revenues indicate the total amount that your customers pay for selling goods and services to them. However, at times your customers may not make the full payment against the invoices sent across to them.
This means your total business revenues may reduce on account of returns, discounts, and allowances. Therefore, you need to adjust such items to compute net sales for your business.
So, to calculate the net sales, follow the steps below:
- Examine Net Sales Formula
As mentioned earlier, net sales are nothing but gross sales less sales returns, allowances, and discounts. This figure is important for various stakeholders such as investors and owners.
Net sales showcases precisely the amount of revenue your business generates. Typically, these revenues are generated when you sell your products or services.
However, you can also generate revenue from other activities like the sale of plant machinery, etc.
- Use the Accrual Method of Accounting
You need to use an accrual method of accounting while recording sales in your books of accounts. This is because the accrual method of accounting recognises revenue when it is earned and expenses when they are incurred. That is the accrual method of accounting matches revenues with expenses during specific accounting periods.
This method of accounting gives a better picture of your business earnings relative to the cash method of accounting. The cash method of accounting recognises revenues when cash is received and expenses when cash is paid.
Thus, using the accrual method of accounting you can recognise revenue from sales the moment you send invoices to your customers. You do not have to wait for the cash payment to recognise sales in your books of accounts.
- Calculate Gross Sales
As mentioned earlier, gross sales are the total goods and services sold to your customers during a specific period of time. As per the accrual system of accounting gross sales are the total dollar amount of invoices you send to your customers to request payment.
- Deduct Sales Return, Discounts, and Allowances
Sales returns are goods that your customers return due to poor quality or damage. Thus, you need to subtract sales returns from gross sales. The accounting effect of this would be an increase in the sales returns account and a decrease in the accounts receivable account.
Next, you need to deduct any sales allowance from gross sales. Sales allowance is a grant that you provide as a seller to your customer. This may be due to incorrect pricing or an error in the number of goods shipped. Finally, you need to deduct a sales discount if you are offering one to your customers.
- Record Net Sales
Once you deduct sales returns, discounts, and allowances from gross sales, the remaining figure is your net sales. Now, you need to record the net sales in your income statement. Typically, a firm records gross sales followed by allowances and discounts. The resulting figure is your Net Sales.
Net Sales Minus Cost of Goods Sold
Net sales minus the cost of goods sold is the gross margin of your business. It refers to the revenue that remains after considering the direct costs related to the manufacturing of products or services that you sell.
In other words, gross margin is the amount of profit that remains before deducting selling, general, and administrative, and interest expenses.The higher the gross margin, the higher the capital your business retains on every dollar of sale.
Thus, the formula for gross margin is:
Gross Margin = Net Sales – COGS
where, Net Sales = Gross Sales – Sales Returns, Discounts, and Allowances
COGS = Direct costs related to producing goods and services. These include direct material, direct labour, etc.
Remember, gross margin is an important figure that investors and other stakeholders keep a track of. This is because gross margin indicates the part of each dollar of revenue that your business retains as gross profit.
For instance, your business retains $0.20 for every dollar of revenue generated. Provided it has a quarterly gross margin of 20%. Further, it also means that the amount retained can be used towards paying debts and other expenses.
In addition to this, businesses also use gross margin to understand the relationship between their productions costs and revenues.
Net Credit Sales Formula
Net credit sales are sales made on credit. In other words, net credit sales are the revenues your business generates on account of selling goods to customers on credit. This means that net credit sales do not include any sales made on cash. Furthermore, net credit sales also take into account sales return and sales allowances.
This accounting item is used to calculate various other financial analysis items like days sales outstanding and accounts receivable turnover ratio. Besides this, net credit sales also indicate the amount of credit you offer to your customers.
Net Income Vs Net Sales
|Net Sales||Net Income|
|Definition||Net sales are the sales that account for certain adjustments made once the goods are sold.||Net income is the net profit which is the sales revenue less the operating expenses and cost of goods sold.|
|Formula||Net sales is equal to gross sales less sales returns less sales allowances less sales discount.||Net income is equal to net sales less COGS less operating expenses less other expenses.|
|Representation In Income Statement||Net Sales represent the top line of the income statement.||Net Profit represents the bottom line of the income statement.|
|Dependency||Net sales are independent of net income.||Net profit is dependent on net sales.|
|Purpose||Net sales reflect the total sales activity of your business||Net income reflects the profitability of your business|