What Is the Formula for Determining Net Income?

Net income represents a business’s financial outcome over a specific period, typically a quarter or a year. It measures the profit remaining after all revenues are collected and all expenses and taxes are paid. Understanding net income is important for evaluating a business’s financial health, whether for investment, performance assessment, or general insight. It indicates profitability, revealing how effectively a company manages sales, costs, and tax obligations.

The Core Formula

Net income calculation follows a straightforward formula, foundational to financial reporting. It subtracts a business’s total expenses and taxes from its total revenue. Revenue is the total monetary value from sales of goods or services. Expenses encompass all costs incurred to generate that revenue, from operational costs to the cost of sold goods. Taxes represent mandatory government levies on the business’s profits.

Understanding Revenue

Revenue is the total income a business generates from its primary activities before any deductions. This inflow typically stems from two main sources: product sales or service provision. Sales revenue comes from selling tangible goods, like apparel or electronics. Service revenue is earned by businesses providing intangible services, such as consulting or software subscriptions.

Revenue recognition timing is governed by specific accounting principles, such as Accounting Standards Codification 606. This guidance dictates revenue recognition when control of promised goods or services transfers to the customer. For many transactions, this occurs at the point of sale. For services or complex contracts, revenue may be recognized over time as performance obligations are satisfied, ensuring income is recorded only when earned through value delivery.

Understanding Expenses and Costs

Expenses and costs are outflows a business incurs to generate revenue, categorized by their relationship to operations. A significant category is Cost of Goods Sold (COGS), which includes direct costs for producing sold goods. For manufacturers, COGS encompasses raw materials, direct labor, and manufacturing overhead like factory utilities. These costs are directly tied to each unit sold.

Beyond COGS, businesses incur operating expenses for day-to-day activities not directly linked to production. Common examples include administrative staff salaries, office rent, and utility bills. Marketing and advertising costs also fall into this category. Depreciation and amortization are non-cash expenses allocating the cost of long-term assets over their useful lives. Depreciation applies to tangible assets like machinery, while amortization applies to intangible assets such as patents or software licenses.

Non-operating expenses are not directly related to core business operations but still impact profitability. Interest expense, for example, is the cost of borrowing money for business activities, like interest paid on a bank loan or corporate bonds. Losses from asset sales, occurring when property or equipment sells for less than book value, also represent a non-operating expense. All these expenses are deducted from revenue to determine profit before taxes.

Accounting for Taxes

After revenues and expenses are subtracted, the remaining amount is subject to income taxes. This primarily refers to corporate income tax, a levy imposed by federal and state governments on a company’s taxable profits. The federal corporate income tax rate in the United States is a flat 21%, established by the Tax Cuts and Jobs Act of 2017. This rate applies to income before taxes.

Most businesses also face state corporate income taxes, which vary significantly. Rates can range from 0% to over 11%, with some states using a flat rate and others a graduated system. Businesses typically deduct state income taxes when calculating federal taxable income, reducing their overall tax burden.

Putting It All Together: An Example

To illustrate net income calculation, consider a hypothetical manufacturing company for a fiscal period. This company generates $1,000,000 in revenue from product sales. Producing these goods incurs a Cost of Goods Sold (COGS) of $400,000. Subtracting COGS from revenue yields a gross profit of $600,000.

Next, the company’s operating expenses are factored in. These include $200,000 for salaries, $50,000 for rent, $20,000 for utilities, $30,000 for marketing, and $40,000 for equipment depreciation. Total operating expenses sum to $340,000. Subtracting these from gross profit results in an operating income of $260,000.

The company also incurs $10,000 in interest expense on outstanding loans. Deducting this from operating income provides income before taxes of $250,000. To determine net income, the tax expense is calculated. Assuming a combined federal and state income tax rate of 26% on the $250,000 income before taxes, the tax expense is $65,000. Subtracting this tax expense from income before taxes yields a net income of $185,000.