Revenue Accounting 101: The Basics
Accounting is a fundamental component to the operation of a business. Without it, you’d never know how much money was coming or going which would paint a very vague picture of overall profit or debt. Revenue is a financial accounting term that means incoming money. This is different than profit which is incoming money less expenses. It’s important to understand the differences between these two terms as they are often used synonymously but they are actually distinct financial keywords. Revenue accounting is the process of tracking, receiving, accounting for and collecting funds coming into the company. In the course Financial Accounting Basics learn accounting fundamentals.
Revenue vs. Profit
Before we can delve into the accounting aspect of revenue, I’d like to further demonstrate the difference between revenue and profit. We will use Joe’s Ice Cream Shop as an example.
Joe sells ice cream. He has been in business for over ten years so to further deepen his overall profits he invested some money in a start-up restaurant down the road. This year, his return on investment was approximately $5,000. From his ice cream sales he brought in over $20,000 in the same year.
Joe’s total revenue is $25,000 for this year.
$5,000 (investment return) + $20,000 (sales) = $25,000 (revenue)
Now, Joe knows that in order to make money – you have to spend money. He initially invested $1,000 to the start-up restaurant and he spent $7,000 on buying his ice cream supplies and marketing his business (the cost of these supplies is called cost of goods and services (COGS)). So, Joe’s profit is $8,000 less than his total revenue.
$1,000 (investment) + $7,000 (cost of goods and services) = $8,000 (expenses)
This means that Joe’s total profit is his total revenue minus expenses.
$25,000 (revenue) – $8,000 (expenses) = $17,000
See the difference? There are other expenses like operating costs and product returns or applied discounts, too. That’s for another article.
Okay, so revenue is all of the money coming into the company. This is a bit deceiving of a number as no taxes, expenses or accounts payable are taken into account when calculating this number. Revenue is often referred to by most companies as turnover or the top line. Top line refers to revenue’s position on a financial report. It is the umbrella number at the top of the report with all of the detailed information about spending and expenses listed below. Contrarily, the bottom line is net income which shows actual profits that the shareholders of the company are entitled to. For more information about financial accounting, check out the course An Introduction to Financial Accounting.
There are two popular methods of revenue accounting used worldwide, cash basis accounting and accrual basis accounting. These avenues of accounting are strictly governed by accounting regulatory standards like generally accepted accounting principles (GAAP) and the International Financing Reporting Standards (IFRS). Read more about accounting principles in this article.
Cash basis accounting is pretty simply. When a job is done, or a product purchased and the customer pays – you record it in your financing book. You would not record any payment or expense of a financial transaction has not occurred. This is opposite to the accrual basis accounting method.
Accrual basis accounting is a popular method of tracking costs and revenues. The fundamental practice of this method requires the company to record all revenue or costs in the books regardless if the money has been received or paid. For example, I agree to cut Mark’s lawn. I show up on Saturday and finish the job. He doesn’t pay me, but says he will next week. I go ahead and add the payment as income on my budget – even though I haven’t been paid. Likewise, if Mark cut my lawn and I decided to pay him in two weeks, I would mark this as an already incurred expense in my budget.
Types of Revenue
As we saw with Joe’s ice cream shop, revenue can come in different forms. General revenue, or revenue produced by sales of goods or services is the most typical kind of revenue for a business to have. However, if there are investments made or perhaps property rented out at the business location to another entity, these would be recorded as separate from sales revenue as other revenue on a financial report. This conveys that the other revenue is not a central income for the company, instead, more peripheral. Learn how to uncover more revenue options in this course.
Sales revenue is a term in revenue accounting that shows the total revenue of a company less the cost of damaged, discounted or returned products. Sales revenue is also sometimes called net revenue or net sales. Sales revenue does not include taxes nor does it include any incidental income gained from interest on loans or sitting savings accounts.
Using Revenue in Accounting
When you isolate the revenue figure – it’s not exactly forthcoming. It means nothing unless it’s applied a series of calculations to end up with the gross margin and net income. These two figures are the true indicators of the health of a business. To calculate the net income we use the following formula:
Revenue (assets coming in) – expenses (assets going out) = net income (profit)
Let’s use Joe’s ice cream shop again. We know that he had a revenue of $25,000 and his cost of goods and services was $7,000. We need to account for his operational expenses which includes overhead like rent, utilities, payroll and taxes. Joe’s operational expenses are $6,000 for the year. So now we can use the figures to find his net income or the bottom line.
$25,000 (revenue) – $7,000 (COGS) – $6,000 (operational expenses) = $12,000 (net income)
There are other equations we can do to find out the gross margin and the profit margin. Gross margin explains how well sales revenue covers the costs associated with making the goods being sold. The profit margin is a calculation done to identify how well a company turns revenue into profits. This is an important figure to find out if your company is seeking investors. Here are the formulas:
revenue – cost of goods sold = gross margin
net income/sales = profit margin
Let’s use Joe again. We know his revenue, net income, sales and cost of goods sold so now we just plug in the numbers.
$25,000 (revenue) – $7,000 (COGS) = $18,000 (gross margin)
In this circumstance, Joe’s COGS are very well covered by his sales revenue. Remember, Joe’s sales for this year were $20,000.
$12,000 (net income) / $20,000 (sales) = .6 or 60% (profit margin)
That is huge profit margin. Investors would be happy to see this number and would likely want to invest their money into the growth of the business.
So while revenue accounting is very detailed at its core, it’s mostly about keeping accurate and clear financial records throughout the year and then applying basic math to get the top and bottom line figures – and everything in between. For a more tips on how to manage your business finances, try the course Your Business by the Numbers.
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