How to Calculate Net Sales

By Markets Fool.com

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Source: Motley Fool

In many cases, the difference between net sales and gross sales can be much more than an accounting detail. Let's take a look atApple and why net sales can be a relevant concept providing a lot of information about the health of the company's different business segments.

Net sales vs. gross sales
When a company records revenue on a gross sales basis, the full amount of the transaction is recorded in the income statement as sales. On a net sales basis, on the other hand, the company only records as sales a commission for the transaction.

For example: If Apple sells a song for $1 under the gross sales method, the company would record $1 in revenue. Assuming that Apple then has to pay $0.70 to the record company, that $0.70 would be registered as cost of goods sold. Gross profit would amount to $0.30, which is the difference between the revenue recorded and the cost of goods sold.

However, if the transaction is accounted for via the net sales method, Apple would only record $0.30 in revenue. Gross profit would be the entire $0.30, as Apple has never included the $0.70 it paid to the record company as revenue.

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Evidently, revenue, gross profit, and overall financial statements can look very different depending on whether a company chooses one method or the other. Investors need to pay close attention to when a company is reporting net sales vs. gross sales and what that says about the business.

When to choose net sales or gross sales
Accounting rules allow some room for flexibility in this area. However, the Financial Accounting Standards Board, or FASB, has issued some guidelines, which can be quite helpful and illustrative.

When a company is the primary obligor in the transaction -- meaning that it's responsible for providing the product or service to the buyer -- then the gross sales method is preferred. If this responsibility lies with the supplier, then the net sales method is a better choice.

Inventory risk is also an important consideration. If the company is buying the inventory before selling it to the customer, then it needs to record gross sales, because it is the one that would lose money if it is unable to sell such inventory.

Similarly, if the company is assuming credit risk -- meaning that it would take a loss if the customer does not pay -- then the transaction should probably be accounted for under the gross sales method. But if credit risk lies with the supplier, then the net sales method is the better choice.

If the company can select among different suppliers for a transaction, or if it can set the sales price, that means it's the one calling the shots, so it should record gross sales. On the other hand, if it makes a fixed sales commission for every transaction, regardless of the sales price, then it should go for net sales.

Net sales and gross sales in real life
Apple is an interesting example to analyze. The company recognizes revenue under the net sales method in some segments and under the gross sales method in other segments. Hardware devices are clearly recognized as gross sales, and the same goes of the software and services the company sells directly to customers. On the other hand, third-party apps are registered as net sales.

The company explains how this works in its latest 10-K report:

For the sale of most third-party products, the company recognizes revenue based on the gross amount billed to customers because the company establishes its own pricing for such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its customers.

For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the company to third-party app developers and certain digital content owners is not reflected in the company's consolidated statements of operations.

Apple typically charges a 30% commission on third-party apps, so when you see app revenue for $30 in the company's income statement, this is probably accounted for on a net sales basis. This means that the actual value of the transaction was probably in the neighborhood of $100.

The article How to Calculate Net Sales originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.