Why is the Net Sales Formula Important?
First, let's start with the definition of net sales vs. gross sales. Gross sales tells you how much a company has made in total sales, but it doesn't tell you how much a company has actually earned in profit. Net sales is an indicator that will give you a more clear picture of a company's performance because it accounts for sales money that was returned to the customer after the transaction. Relying on gross sales alone can lead analysts to overestimate a company's financial status.
After a sale is made, the transaction is not yet over. A business must account for product returns, damaged goods, and customer rebates. A business might earn $150,000 in sales, but they could end up losing $25,000 of that money due to faulty or incomplete transactions. To account for this, you can calculate net sales by subtracting returns and allowances from gross profit. Allowances, in this case, are allowances for discounts on products that are sold. For a car company, they may have allowances for a questionable part that could be recalled. It allows a company to preemptively account for defective merchandise. Alternatively, a car manufacturer could choose not to make low quality products in the first place.
How to Calculate Net Sales
Here's a quick example:
Cynerga, Inc. has gross sales of $1.2 million. They have $20,000 in returns, $10,000 in damaged merchandise, and $5,000 in rebates. We need to subtract returns, damaged goods, and rebates ($35,000) from the gross profit ($1.2 million), which gives us $1,165,000 in net sales.
This example will show how to use net income to quickly compare businesses:
Company A has gross sales of $500,000 and net sales worth $350,000. Company B has gross sales of $400,000 and net sales of $385,000. It may be tempting to say Company A is more successful because they make more sales, but with their high number of returned and damaged goods, they are actually bringing in less money than Company B.