The key to proper performance evaluation is using the correct baseline which is most often net sales. As in the example above, $120,000 is gross sales and $116,000 is net sales. So what exactly does this mean – gross and net?
The best way to explain the difference between the two is as follows:
Gross Sales – Sales the customer actually purchases at the register based on normal price structure.
Net Sales – The amount the customer actually pays for the product they keep.
In general there are two groups of value reductions to gross sales including incentives and adjustments to get to net sales. These are explained and illustrated in the relationship section below. In addition there are a couple of different reporting formats for the accountant to use including industry standards. Finally, some unique presentation formats for certain industries including franchise operations, construction and housing rental are illustrated.
Remember, the primary goal is to establish an accurate net value to measure productivity and operations.
Gross and Net Sales Relationship
In retail the single most common adjustment to sales are returns. Think of December 26th each year at every major retailer. To calculate the actual amount sold a business must adjust for certain groups of reductions – Incentives and Adjustments.
Incentives are enticements or directly related costs to get the customer to buy the product. Incentives consist of discounts, coupons, campaigns and third party commissions. The following explain these types of incentives in more detail.
* Discounts – Generally considered a reward for buying in volume or purchasing a particular product or product line. Discounts are typically issued to regular customers as a form of respect for their loyalty to the business. Examples of discounts include:
– Buy four and get the next one free like in sandwich shops or pizza parlors
– Auto repair shops offer discounts for purchasing sets of tires or getting all brakes replaced
– Pay early or with cash and get a percentage discount off the price
* Coupons – Unlike discounts, coupons are used to bring in new customers or get existing customers to purchase more of a particular product. This is one the most popular incentive programs in modern merchandising. The most common form is the gift – ‘Act now and you’ll receive a free …’.
* Campaigns – Programs with a theme or direct advertising related to this program are called campaigns. The best example of businesses that utilize campaigns are dealerships and furniture retailers. They often run end-of-the-month special sales or holiday sales to incentivize the customer to act. The usual costs involved with the campaign include TV, radio, direct flyers and decorations.
* Third Party Commissions – This one is more common than what readers realize. When a professional marketer or broker of some sort is hired to bring the customer to the business and get the customer to buy the product, the payment to the professional is often a percentage of the sale. Two of the more rarely used examples are professional fundraisers (used often in non-profit fundraising) and real estate brokers for new home contractors. But the most common is franchising explained later.
When the sale is completed the sale is recorded at full price and the corresponding incentives are debited for the respective dollar value related to that sale or group of sales (like a weekend campaign).
Incentives are very common in highly competitive environments where getting the customer to walk in the door is the hardest part. These include:
Specialty Retail Auto Repair
Amusement Parks TV Sales via Commercials
Unlike incentives where the business is nudging the customer to buy the product, adjustments occur after the product is purchased. Here the customer is dissatisfied with the product or doesn’t need it and either brings it back or wants some form of value to retain the product. There are two types of adjustments and they are allowances and returns.
Allowances – When a customer is dissatisfied with the product they usually want to return the product. It is in the best interest of the business to eliminate returns but still keep the customer satisfied. Returns cost money to process and can impact overall sales in the long run. So an alternative exists – allowances. Allowances are merely a credit to the customer to rectify their inconvenience with the product. Often the company proposes a financial credit to the customer’s account to keep the product. Here are some examples:
* An electrical supply company has electricians as customers. Often the electricians receive too many of a certain part or wrong part. Via phone calls the customer can explain the situation to the sales rep. The representative issues a credit to the account for 10% to 30% depending on the case variables to get the electrician to retain the part.
* A food distributor often errs in providing the wrong flavor or too much of a particular food product. To compensate for these errors, the distributor offers allowances to reduce returns.
* Highly specialized product companies usually mis-produce the product, think of a printer or sign company. To prevent a return of a product they can’t resell, these companies use allowances to get their customers to fully accept the customized item.
Returns – Returns are the physical act of bringing the product back to the store. There are three categories of returns:
1) Exchanges – With exchanges the customer swaps the purchased product for the correct color, size or other physical characteristic. Basically the customer selected the wrong product initially and desires the correct product.
2) Defective – Sometimes the product itself is defective or damaged; so the item is brought back similar to an exchange.
3) Customer Error – Unlike exchanges the customer is simply stating that they erred in their purchase and are returning the item. Common reasons include purchasing too many, inability to afford the item or the item isn’t what they anticipated.
As a side note to returns, the accounting software can use a coding system to track three categories of returns to determine product issues or salesman misrepresentations.
In a simple financial reporting format the sales section looks like this:
Net Sales $ZZZ,ZZZ
In a detailed format it may look like this:
Sales (Gross) $ZZZ,ZZZ
Sub-Total Incentives (ZZ,ZZZ)
Sub-Total Adjustments (ZZ,ZZZ)
Net Sales $ZZZ,ZZZ
This format is set up in the chart of accounts by establishing two parent-child accounts (incentives and adjustments) as contra accounts in sales. As the actual expense is incurred there is a debit to the correct contra account. Here is an example of a journal entry for a sale associated with a $3.00 off coupon.
The sales section is designed based on the particular industry. Retailers will need both groups of reductions as incentives and adjustments are quite common. For specialized product manufacturers it is rare to have incentives and more common to have allowances as an adjustment to gross sales. Allowances are also the most common reduction for contract work especially professional service firms like legal, medical and engineering. Whereas the food industry utilizes incentives to a strong degree. Many business operations have very complex gross to net sales structures.
INCENTIVES ARE COSTS TO BRING A BUYING CUSTOMER TO THE STORE. THEY INCLUDE DISCOUNTS, COUPONS AND THIRD PARTY COMMISSIONS. ADJUSTMENTS ARE REDUCTIONS TO SALES AFTER THE CUSTOMER TAKES POSSESSION OF THE PRODUCT. THEY INCLUDE RETURNS AND ALLOWANCES.
Specialized Presentation Format
Incentives are costs to bring the customer to purchase the product. The most volume based driver of incentives is franchising. This is a relationship whereby the name and brand cause the customer to act. The customer shops at this store over a similar store because of the name. In addition franchisors often have campaigns through their advertising to get more customers to the store.
Franchise Presentation Format
With franchising the sales section presentation is designed for the franchisee. The franchisee is interested in the point of the sales structure where he no longer has to pay a percentage (royalty) to the franchisor. In effect, its his money (net sales). In franchising, the royalty fee is commonly 5% to 8%. So let’s look at how a Subway shop should report the sales section of their income statement.
Notice there are no adjustments? Why?
The restaurant industry never has returns, they simply remake a sandwich if the customer is dissatisfied. No allowances are offered; yes every now and then they’ll give the customer a soda or cookie for inconvenience but it is rare because the cost to track the information exceeds the value derived.
Remember, a royalty fee is like paying a commission to a broker for bringing a buying customer to your store.
Construction Presentation Format
* Discounts – Customers want the project completed by a certain date or else they suffer some form of inconvenience. Contracts are written to penalize or discount the price of the contract for failure to complete the contract on time.
* Coupons – Not Applicable
* Commissions – Many contractors pay a fee to third parties to bring them a signing customer. The most common is new home contractors that pay real estate brokers a commission for a signed contract.
* Allowances – In the construction industry there are two types of allowances. The first relates to the actual construction of the home or structure. This includes a dollar value for appliances, cabinets, fixtures etc. It is explained in more detail in this article: Allowances in Construction. This allowance is for physical property. The second type of allowance relates to the sale. Sometimes it acts like an incentive to sign the contract and includes some form of payment of closing costs. Other times it is exactly like the definition of the adjustment allowance explained earlier. Here the contractor screwed up during construction and used the wrong material or size and can’t take it back. Therefore an allowance is provided at closing to rectify the discrepancy.
The following is an example of the sales section of a project’s income statement for a new home contractor.
What is interesting is that this information is often found on the HUD form at closing.
Notice that the gross sale doesn’t start at the final contract value. This is because the goal of this exercise is to evaluate costs to sign and close a deal. This allows management to adjust for contractual issues in the future. I write extensively about this in several articles in the construction industry section.
In some industries, the gross sales reported is actually the maximum possible during the accounting period. The incentives and adjustments relate to reductions to net out for revenue. The following section illustrates one such industry.
Apartment Complex Reporting
Interestingly enough the housing rental industry financial reporting doesn’t focus on profitability as it does efficiency. Profitability in this industry is really a function of equity growth in value for the complex than the financial profit. The income statement is driven to identify inefficiencies in utilization and management, i.e. maximum occupancy. The sales section of the income statement is very extensive and informative and uses several of the incentives and adjustments to equate net rental revenue.
The following is a typical complex rental income section of the profit and loss statement. Explanations are included at the bottom as denoted by the corresponding letters.
WAYMONT GARDEN APARTMENTS
Rental Revenues Report
For the One Month Ending January 31, 2016
Maximum Market Rents (220 Units) $207,300 (A)
Showcase Units (2,475) (B)
Maximum Available Rental Income $204,825
Contractual ($7,290) (C)
Campaigns (6,400) (D)
Referrals (2,350) (E)
Sub-Total Incentives (16,040)
Unavailable Units (1,810) (F)
Tenant Credits (440) (G)
Sub-Total Adjustment (2,250)
Collectible Rents (Net Rents) 186,535 (H)
Collected Rents (184,905) (I)
Uncollected Rents $1,630 (I)
(A) The value if every unit is rented at the set market rate based on the apartment size and amenities.
(B) Three units are reserved for showing and have staged furniture. Each unit is a variable (1,2,3 bedroom) of what is offered.
(C) Contractual reduction relates to timing of lease signing. Some leases were signed under older rates and are grandfathered as to the amount earned per accounting period. Other leases are discounted for tenant performance including security and on-call services.
(D) Rental adjustments related to a particular program such as ‘Last Month of Rent is Free’ or rent reduction for extended leases.
(E) Some tenants take advantage of a referral program and receive money to refer a new qualified signing tenant.
(F) Some units are removed from availability during the period to conduct maintenance and complete upgrades.
(G) Tenant credits are similar to allowances; sometimes something happens to harm the tenant (sewage backup, non performance by the complex, etc.) so a credit is issued to alleviate the tenant’s inconvenience.
(H) Collectible rents represent the actual maximum amount of rent that can be collected from existing tenants and unoccupied units.
(I) The relationship between actual collections and uncollected rents is a reflection of management’s ability to rent out all available units.
This presentation format is actually a multi-step information driven report for owners. The maximum market rent identifies the absolute perfection in apartment complex operations. It identifies the maximum potential rent if every unit is rented at current market rates without any incentives or adjustments. The incentives section is really nothing more than total marketing costs to get signatures on leases. The adjustment section reflects the inability to keep all the units available 100% of the time. So two to four units per month are offline for repairs and upgrades. In addition, group housing has its share of community issues necessitating some form of remedy to existing tenants; especially those that have been with the complex for a long period of time. Based on the information provided, owners can identify the source issues with maximizing rental income.
Summary – Gross and Net Sales
Gross sales reflects actual purchases at regular price. The difference between gross and net sales is a result of reductions grouped into incentives and adjustments. Net sales is the actual amount a customer pays to purchase and retain the product. Incentives include discounts such as volume incentives or payment with cash; coupons and campaigns which reflect programs to bring the customer to the store to buy or try new products; and third party commissions such as franchise fees or broker fees.
Adjustments are reductions from actual customer sales to get the customer to keep the product. Adjustments include allowances for imperfections with the product or errors in delivery of quanity or quality. Returns are divided into three categories: 1) exchanges, 2) defective product or 3) customer error. Only with defective items and customer errors are refunds issued.
Presentation formats are used to identify areas of costs or performance by staff. Good presentation and industry specific presentation formats allow management to easily identify issues with sales performance. Overall, good organization and monitoring of incentives and adjustments can make significant improvements to net sales and ultimately the bottom line. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.