Why is the Net Sales Formula Important?
First, let's start with the definition of net sales vs. gross sales. The gross sales formula 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. A net sales total 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 consider 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 products or incomplete transactions. To account for this, you can calculate net sales by subtracting returns and allowances from gross profit. Returns, of course, means the value of any products that were returned by customers. Allowances, in this case, are allowances for discounts on products that are sold. This gives a company some wiggle room for special promotions and sales. For a car company, they may have allowances for a questionable part that has the potential of being recalled. It basically allows the 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. At first glance, it appears that Company A is more successful because they made $100,000 more in sales than Company B. However, with their high number of returned and damaged goods, Company A is actually bringing in less money than Company B.
Who Uses This Accounting Indicator?
The total net sales of a business is of extreme importance to potential investors. Before buying into a company, investors want to know if there is a stable track record of sales growth. They can review past sales data and other accounting figures to make this determination. If they find financial stability, they gain confidence that the company's leaders will continue to steer the enterprise toward profitability. If the company can make a steady profit, so could an investor.
Managers, company executives, and other decision makers within a company are also interested in this data. They want to know what direction their company is going so they can properly adjust their strategies. If they are losing sales on a particular product, they know it's time to either drop the product or reconsider how to sell it. If they see growth, they know their efforts are effective and can replicate that success more easily in the future. Business leaders also need to report net sales data to the company's stockholders.
The stockholders want to know about the company's sales so they know if their investment is safe. If they see the company's revenues plummeting, they may consider selling their stock to cut their losses. On the other hand, if they see an increase in sales, they may choose to hang onto the stock longer before selling.