Net income and doing business are strongly linked. New companies are being opened precisely to generate income. Entrepreneurs are actively developing ways to increase the profitability of the business and use material and labor resources more effectively. Therefore, it is important for any business owner to understand the concept of net income.
Definition
Net profit is one of the key indicators of the success of the company. This is the proceeds from sales and other income of the business minus all expenses, including taxes. It is quite logical that any management wants to derive maximum profit from the activities of their company. Such a result is needed both by owners, top-level managers, and line specialists because it is this indicator that shows the effectiveness of the whole work.
The amount of net income is the most accurate evidence of the efficiency of the enterprise. If this amount increases in comparison with the previous period, then management is doing a great job, while its decrease indicates errors in the chosen strategy and policies.
Calculation
Net Income = Revenue from the sale of goods and services – Variable expenses – Fixed expenses – Non-operating expenses – Income tax
Net income is the remainder of the revenue after deducting all the expenses:
- Variable expenses are costs that depend on the volume of production or services provided and can include raw and other materials, energy resources, salaries of employees involved in the main activities of the organization, etc.
- Fixed expenses include rent of premises, salaries of management personnel and security personnel, property taxes, depreciation costs, that is, all costs that do not depend on production volumes.
- Non-operating expenses are expenses necessary for running a business, but not directly related to the production and sale of the product or provision of service. For example, fulfillment of loan obligations, payment of fines and legal costs, etc.
- Income tax is calculated based on the local and federal tax rates as well as the amount of income the business has earned.
This is just one of the methods for calculating the final financial result of business operations. The essence remains the same – it is the difference between the income and expenses of the company after accounting for all the expenses, including tax payment.
Example
In 2020, Bicycle Shop Inc. sold ten bicycles for $1,500 and bike accessories for $5,400. The goods it purchased from a supplier cost it $6,000. It also paid $5,000 in wages, $2,000 for rent, $500 for insurance, and $1,000 in taxes. To calculate the net income using the formula above, the following algorithm is used:
- To calculate the sales income (revenue) that the business has earned during the period, we would multiply $1,500 by 10 and add $5,400. This gives us a revenue of $20,400.
- Now, we subtract variable costs from the result. This way we will find out the company’s marginal profit. Variable costs here are the goods purchased from the supplier for $6,000. Thus, we get $14,400.
- Further, according to the formula, it is necessary to subtract the amount of fixed costs from the result of the previous step. We get an operating income of $6,900.
- Our next step would be to subtract all other expenses, but there were none for the Bicycle Shop Inc. All this is done to calculate the amount of profit before taxes are paid.
- Now, we can subtract the taxes of $1,000. We arrive at the net income for Bicycle Shop Inc. of $5,900.
How to increase the company’s income
Net income is the basis for further growth and development of the enterprise. The larger it is, the more profitable the business, which means it is more attractive to investors. Strong financial results testify to the organization’s solvency and expand opportunities for lending and cooperation with suppliers.
Motivating your employees is one of the most powerful ways to improve your bottom line. Rewarding employees for good work and achievements is the way to go. In fact, there are numerous ways to reward them without giving them money, such as recognition, learning opportunities, extra responsibility, job titles, and a sincere word of thank you. This will push them to put as much effort into their work as possible.
The introduction of new technologies, automation of production will lead to the possibility of reducing the number of employees, and, accordingly, will reduce the cost of wages or allow your workers to increase the quantity and/or quality of their work.
The riskiest way would be to increase prices. To use this method, the manufacturer must be confident that buyers are ready to purchase the product, even when prices rise. Another way is to reduce costs. At the same time, it is important to understand that cost reduction almost always leads to a decrease in quality. Thus, this method is more suitable for mass production.
You can also read the article “Gross vs Net” in our blog.
