How do I calculate my bottom line using the net income equation?
In this post, we’re talking all things net income and how to calculate it. We’ll go through factors affecting your net earning and what you can do to mitigate them.
What is Net Income?
Net income, also popularly known as net profit, refers to the money left over after deducting operating costs, taxes, interests, and other expenses. This is not to be confused with retained earnings which is the amount left over after paying dividends. ware For businesses, net income accounts for both operating and non-operating income and expenses.
For individual net income, it is what you take home after accounting for deductions and taxes.
Why Is Net Income Important?
Since net income is your bottom line, it’s an important metric that helps measure business health and performance. It shows you the amount of money you can use to funnel back into business operations, distribute to shareholders, pay debts, or save until needed. Net income is one factor investors look at to determine how profitable a business is. It is essential to calculate earnings per share (a measure of company profitability) price to earnings (P/E) ratio and retained earnings.
Components of Net Income
Gross Income vs. Net Income
Gross income refers to the revenue earned by a business after deducting COGS or cost of goods sold. This is the total profits without taking expenses into account. You need to find this before you can calculate net income. The gross income equation is Revenue – COGS. Basically, net income is income after expenses. Gross income is income before expenses after production costs.
Revenue and Sales
Revenue refers to total profits and cash inflows from various sources of income. These sources can include investments, donations, liquidation of assets, or revenue from selling goods or services. This is known as your top line because it is the first entry on an income statement. Sales refers to income generated through a business’ sales activity of offered products or services. Sales revenue is a subset of revenue. Some businesses only have sales revenue and subtract cost of sales (another term for COGS) in order to get gross income.
Operating Expenses
These are expenses incurred during core business activities. These are overhead costs that allow a business to continue running and are a key part of the net income equation. Operating costs include but are not limited to:
- Rent
- Utilities
- Inventory-related costs
- Payroll
- Equipment costs
- Marketing and advertising costs
Operating Income
This is the income left to you after deducting operating expenses before subtracting income tax. You can consider this as the net income earned through core business operations. The formula for operating income is:
Gross Income – Operating Expenses = Operating Income
Non-Operating Income and Expenses
As the name suggests, these are additions and deductions from other business activities. Companies can list these as gains and losses on an income statement. These non-operating expenses and income include:
- Exchange rate changes
- Losses or gains from investments
- Amortization and depreciation
- Dividend profits
- Non-recurring expenses and incomes (donations, loss by natural disaster, etc.)
Taxes
These are federal/state income taxes given to the government. The amount your business owes in income tax is based on a federal marginal tax rate. Your gross income is also known as your taxable income. Businesses and individuals alike calculate tax deductions at the gross income level. So, you could say that taxable income is gross income minus deductions. We can categorize taxes under “Other Expenses”. You usually list income tax expenses on the line directly above your net income.
What Is the Net Income Formula?
Net Income Formula
There are two ways to calculate net income. One doesn’t account for non-operating expense and income, the other does.
Formula 1: Gross Income – Operating Expenses – Taxes = Net Income
Formula 2: Operating Income – Taxes + Non-operating income – Non-operating expense = Net Income
Net Income Calculation Step-by-Step
1. Know how much revenue you earned total for that reporting period. This period is typically quarterly or yearly.
2. Determine your cost of sales/COGS and subtract it from your revenue to get your gross income.
3. Add all of your operating expenses together and subtract it from your gross income to get operating income.
4. Deduct income tax expense.
5. Account for any non-operating expenses and income.
Finally, you’re left with net income.
Note: Some include a line in their income statement for “Income Before Tax”. This is a calculation of income after adding other expenses and income before subtracting tax.
Net Income Equation Examples
Let’s visualize the net income equation through tables.
Example 1 – Individual Net Income Calculation
For an individual, net income (or net pay) refers to the actual pay received after factoring taxes and deductions. Gross pay deductions go towards federal and state taxes and certain social insurance programs like Medicare or Social Security. Tax percentages vary by location.
(For these 2 examples, we will be making up the tax percentages. )
| Gross Pay | $3,000 | |
| Taxes | ||
| Federal | 10% | -$200 |
| State (if applicable) | – | – |
| Social Security | 5% | -$150 |
| Medicare | 2% | -$60 |
| Deductions | ||
| Healthcare | -$150 | |
| Net Pay | $2,440 |
Example 2 – Business Net Income Calculation
| Net Sales (1 year) | $100,000 | |
| COGS/ Cost of Sales | -$50,000 | |
| Gross Income | $50,000 | |
| Expenses | ||
| Rent, Utilities, Payroll | -$15,000 | |
| Equipment and Supplies | -$10,000 | |
| Advertising and Marketing | -$5,000 | |
| Total Operating Expenses | -$30,000 | |
| Operating Income | $20,000 | |
| Other Income | $500 | |
| Other Expenses | -$200 | |
| Income Before Tax | $20,300 | |
| Income Tax Expense | (12%) | -$2,436 |
| Net Income | $17, 864 |
How Do You Interpret Net Income?
What Are Some Factors Impacting Net Income?
There is so much that can happen during the primary and secondary operations of a business. Many things can directly and indirectly change the net income value for each reporting period.
COGS and Expenses
Costs related to production, manufacturing, operation, and delivery all naturally affect net income. Any variations in these, including inflation, increased fees, increased interest rates, and wages, will impact the bottom line. These costs include:
- Raw material costs
- Supplier fees
- Logistic fees
- Research and Development costs
- Marketing costs
- Hiring and Recruitment Costs
- Overheads (rent, utilities, payroll)
Supply and Demand
All businesses are subject to the law of supply and demand. The customer market affects your top line, which is your revenue, and revenue affects your bottom line. In a competitive environment, it’s all about winning over the customer base. This means imploring tactics through marketing, advertising, events, giveaways and other tactics. These cost money. Whether successful or not, this will become evident in your income statement.
Other Circumstances
Sometimes, there are things that happen beyond our control. Sometimes natural disasters like floods, fires, or earthquakes affect production or destroy products. Equipment might break down or malfunction. You might make an excellent investment outside of primary operations, which funnels back into the business. Your business might attract investors and have additional investment income. You may have to pay legal fees and settlements.
How Can I Improve My Net Income?
Even though there are factors out of our control, there are practical things we can do to positively affect the bottom line.
Reduce your Overheads and Expenses
It’s no secret that a business will operate at a loss for the first few years. So, for your net income to come out to be a net loss isn’t surprising during the beginning. However, if your cost of sales and operating expenses are high, your margins are lower. It will take longer to become profitable. Whatever you can do to reduce operating costs is probably the best way to increase net profits. For instance, you could change the specific materials used or change suppliers and sources to more affordable alternatives. If rent or utility costs are high, you might want to consider moving operations elsewhere.
Reduce Labor Costs
Reducing labor costs can also improve net profits. (And no, we don’t mean underpaying your staff!) For instance, you can look into automation or tech solutions that can do a job more efficiently. You can also try outsourcing your business processes. A lot of businesses outsource to white label manufacturers to make their products. Some countries have better infrastructure for certain processes. This might be much cheaper than creating your own from scratch. Cost of living also affects wages and salaries, which outsourcing can help with.
Frequently Asked Questions
What Are Some Factors That Impact Net Income?
The number of factors affecting net income could be as many processes are involved in a business. These could include:
- Raw material price fluctuations
- Manufacturing costs
- High demand
- Seasonality
- Unforeseen circumstances resulting in gains and losses
How Can I Improve My Net Income?
Reduce operating expenses and cost of sales and reduce labor costs through outsourcing and automation. You can also try investing in low-risk marketing strategies and take advantage of seasonality.
What is the difference between Gross Income and Net Income?
Gross income is income before operating expenses and taxes. Net income is the bottom line you get after you account for all expenses and non-operating factors.
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And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
The net income equation is essential for all business owners to know. It gives you a glimpse into your business operations and informs you where you can better manage your money. There are many factors that impact net income. However, there are also several ways to improve your bottom line so you come out on top!
