How to Calculate Your Net Income: Easy Explanation + Examples

 

Being a small business owner comes with a lot of challenges, especially if you are new to being in business. One of those challenges is learning the terms that go with running a business which includes learning about accounting and bookkeeping.

In this article we’re going to cover the concept of net income, which many people also refer to as profits.

It’s Not As Gross As You Think

Simply put, net income is what is left after you take all the income and subtract all the expenses you have. It’s your income, or “net” of expenses.

It’s why you are in business, or at least one of the reasons. If you never have a profit, you’re going to have a hard time keeping the doors open and you won’t have anything to pay yourself, set aside for retirement, use for growth, or anything else. Knowing this number is the key to running a healthy, successful business!

In accounting, the term gross means things lumped together or a collection of things and the term net means an amount that you get after you take things out.

So for example, your gross sales would be the total amount you collected all together. Your net sales might be the sales you have left after you take out the refunds you may have given.

To put numbers on it, your gross sales for the week might have been $2,000 but your net sales, or sales after refunds, were $1,800.

By the same logic then, net income is the income after all expenses are taken out of your gross income. So if you had sales for the week of $2,000 and then we subtract the refunds and all the other costs for the week, then your net income may be $400.

Let’s Break for Ice Cream

Let’s do an example from the top and include some actual expenses for more of a real world view. Let’s say you have an ice cream shop and we’re looking at one week of activity.

You might have:

Total Sales: $4,000

Cost of Ice Cream: $800

Cost of Employees: $1,200

Cost of Utilities: $150

Cost of Insurance: $75

Cost of Marketing: $200

Cost of Rent: $400

Cost of other miscellaneous stuff: $300

Total Costs: $3,125

So total income of $4,000 minus total expenses of $3,125 equals a net income of $875.

Not a bad week!

Of course this is a pretty simple example and I left out a couple things and I snuck in something I didn’t tell you about.

The COGS in the Machine

The thing I snuck in was a special kind of expense called a Cost of Goods Sold expense, or COGS for short.

The COGS item is the ice cream! If you sell products, then the cost of the product itself is usually the first expense you show when you are adding things up and it gets its own section in accounting. The reason to break it out is so you can track how much you are spending on your products versus everything else because you usually want that to be pretty consistent as a percentage of your sales.

In our example, the ice cream costs $800 out of the total $4,000 in sales. If we divide 800 by 4,000 we get .20 or 20%, which means 20% of the cost of the product we’re selling is the cost of the product itself.

That makes sense; if you go to the store and buy a gallon of ice cream and scoop it yourself, it costs a fraction of what a scoop at an ice cream store costs. But then you don’t have to cover the cost of labor, rent, utilities, etc. and you also aren’t looking to make a profit!

As a business owner, you need to factor all those costs in to what you will charge.

For most product businesses, their COGS is one of their single biggest expenses, so they need to track it carefully, thus it gets its own section in accounting.

There is also a specific term for total income minus COGS, which is gross profit. Unlike net income, gross profit doesn’t subtract all your expenses, it only subtracts COGS.

OK, what are the two things I left out?

I Can’t Feel My Intangibles

In accounting, we sometimes include expenses for things we don’t pay for with cash. These two items are depreciation and amortization. These non-cash expenses are recorded to show a change in value of something over time, but you don’t actually have to cut a check for them.

You’ve probably heard of depreciation; it’s when something loses value. For example, if you buy a brand new car from a dealer and take it home and then try to sell it, you won’t be able to get full price for it. That loss in value is depreciation.

Same thing with your ice cream shop; you may buy a brand new freezer and pay full price, but the moment you want to turn around and sell that freezer, you won’t be able to get close to full price. Even though you aren’t selling it now and no cash changes hands, we can record that loss of value as an expense.

Amortization is the same concept, but it’s used for the loss of value in non-tangible things. It doesn’t come up very often for most businesses.

The most common time you see it is if you buy a business from a previous owner, usually part of the price you pay is for goodwill and that amount loses value over time (since the old owner’s good name and reputation are less valuable the longer you are the owner and put your own stamp on the business).

So if we revisit the example, it could look like this:

Total Sales: $4,000

COGS: Ice Cream: $800

Gross Profit: $3,200

Expenses:

Cost of Employees: $1,200

Cost of Utilities: $150

Cost of Insurance: $75

Cost of Marketing: $200

Cost of Rent: $400

Cost of other miscellaneous stuff: $300

Depreciation Expense: $200

Total Expenses: $2,525

Gross Profit minus expenses = $3,200 – $2,525 equals net income of $675.

Keep in mind, if this was your bank account and all you had in it, you’d still actually have $875 since depreciation isn’t a cash expense; it’s an accounting expense. It helps you pay less in taxes, but it doesn’t actually take money out of your bank account.

Have room in your brain for one more concept? Let’s talk about operating income vs. net income.

Operating on Thin Ice

What if in the course of your ice cream shop business you do decide to sell an old freezer you don’t need any more? And even though you bought it years ago it’s still worth a cool (get it? punny!) grand on Craigslist. And maybe the same week, as a result of some bad luck, you have a small flood and miracle of miracles your insurance company gives you $3,000 to fix the damage, even though it doesn’t cost that much to actually fix?

If you add those two amounts in, where do you put them? And what does that do to your net income?

Normally, the income you record should only reflect money you get from your “usual business,” which in this case is ice cream sales. Selling your freezer and getting an insurance payment is money the business gets, but it’s not what your business “does” so you put it in Other Income, which goes all the way under your last expense. Like this:

… (blah blah the other income and expenses from previous example) …

Cost of Rent: $400

Cost of other miscellaneous stuff: $300

Depreciation Expense: $200

Total Expenses: $2,525

Operating Income: $675

Other Income:

Freezer Sale: $1,000

Insurance Payout: $3,000

Net Income: $4,675

Operating income is showing us what we are making as profit from our normal business, and the net income is showing us what we made after all additional changes were made, in this case gains from an equipment sale and an insurance payment.

You can also have other expenses for things that are outside the normal costs of doing business such as paying a legal settlement if someone slipped and fell because of that ice cream shop flood. It’s an expense and it affects your net income but it isn’t part of your normal expenses of running the business day to day.

For most small businesses, these kinds of things don’t happen often enough to worry about but when they do, this is how we handle it so you can see how much the business made from regular activities versus special events.

A Quick Recap

OK, let’s do a quick recap here of terms and concepts, because I know it’s a lot!

• Gross Sales: the total amount of sales in a certain period of time
• Net Sales: the total sales after deducting adjustments like returns, refunds, discounts, etc.
• Net Income: the total of all income minus all expenses, also known as the net profit
• Cost of Goods Sold (COGS): the cost of the physical goods sold by a product selling business
• Depreciation: an expense that shows the loss in value of a tangible asset
• Amortization: an expense that shows the loss in value of an intangible asset
• Non-Cash Expenses: an expense recorded for accounting purposes that doesn’t actually lower the cash balance of the business
• Operating Income: total sales minus total expenses that are normal for the business, doesn’t include income or expenses outside the normal business operations

If all this sounds like a bit much to keep track of and get right, it definitely can be!

That’s why our small business clients choose to hand over their numbers to a bookkeeping service like us so they can get the reports and use the numbers to manage their business and improve their net income without having to actually spend time learning accounting.

If you’d like a quote for your business, just let us know! We’d be happy to chat and see if we’re a fit for your business needs.