What are net sales?
Net sales are the sum of a company’s gross sales minus its returns, discounts and rebates. Net sales calculations are not always transparent to the outside. They can often be taken into account in the declaration of higher income declared in the income statement.
Understanding net sales
The income statement is the financial report primarily used to analyze a company’s revenue, revenue growth, and operational expenses. The income statement is divided into three parts which support the analysis of direct costs, indirect costs and capital costs. The direct costs portion of the income statement is where net sales can be found.
Companies may not provide much external transparency in the area of net sales. Net sales also may not apply to all companies and industries due to the distinct components of its calculation. Net sales are the result of gross revenue minus applicable sales returns, discounts and rebates. The costs associated with net sales will affect a company’s gross profit and gross profit margin, but net sales do not include the cost of goods sold, which is usually the primary driver of gross profit margins.
If a business has returns, discounts, or rebates, adjustments are made to identify and report net sales. Businesses can report gross sales, then net sales and cost of sales in the direct costs portion of the income statement or they can simply report net sales on the first line and then move on to cost of goods sold. Net sales exclude cost of goods sold, general and administrative expenses which are analyzed with different effects on profit and loss account margins.
Key points to remember
- Net sales are the result of gross sales minus returns, discounts and rebates.
- If net sales are reported externally, they will be noted in the direct costs portion of the income statement.
- Changes in net sales will affect a company’s gross profit and gross profit margin, but net sales do not include the cost of goods sold.
Costs affecting net sales
Gross sales are the total unadjusted sales of a business. For companies using accrual accounting, they are recognized when a transaction takes place. For companies using cash accounting, they are recorded when the money is received. Some companies may not have costs that require net sales to be calculated, but many companies do. Sales returns, rebates, and rebates are the top three costs that can affect net sales. All three costs generally need to be expensed after a business recognizes its revenue. As such, each of these types of costs will need to be accounted for in a company’s financial reports to ensure proper performance analysis.
Sales returns are common in retail. These companies allow a buyer to return an item within a certain number of days for a full refund. This can create some complexity in financial statement reporting.
Companies that allow sales returns must provide a refund to their customer. A sales return is generally accounted for either as an increase in the sales returns and allowances account relative to revenue, or as a direct decrease in revenue. As such, it debits a sales returns and rebates account (or directly the sales revenue account) and credits an asset account, usually cash or accounts receivable. This transaction carried over to the income statement as a reduction in sales.
In many cases, the sales return can be resold. This forces a business to make additional notations to count the item as inventory.
Allowances are less common than returns, but may arise if a business negotiates to reduce previously accrued revenue. If a buyer complains that goods were damaged in transit or the wrong goods were sent in an order, a seller may provide the buyer with a partial refund. In this case, the same types of notations would be needed. A seller should debit a sales returns and rebates account and credit an asset account. This journal entry is posted to the income statement as a reduction of income.
Net sales discounts are generally different from write-offs, which can also be called discounts. A write-off is an expense debit that accordingly reduces the inventory value of an asset. Companies make adjustments for write-offs or write-downs on inventory due to loss or damage. These write-offs occur before a sale is made rather than after.
Many companies working on a billing basis will offer their buyers discounts if they pay their bills early. An example of discount terms would be 1/10 net 30 where a customer gets a 1% discount if they pay within 10 days of a 30 day invoice. Sellers don’t consider a discount unless a customer pays earlier, so ratings should be retroactive.
Discounts are noted in the same manner as returns and allowances. A seller will debit a sales rebate account against the revenue and credit assets. The journal entry then decreases the gross income on the income statement by the amount of the discount.
Net Sales Considerations
If a company provides full disclosure of its gross versus net sales, this may be a point of interest for external analysis. If the difference between a company’s gross and net sales is greater than the industry average, the company may offer higher discounts or earn an excessive amount of returns compared to industry competitors.
Companies generally strive to maintain or beat industry averages. Often returns can be resold quickly without creating problems. Allowances are usually the result of transportation issues that may cause a company to reconsider its shipping tactics or storage methods. Companies offering discounts may choose to reduce or increase their discount terms to become more competitive within their industry.