Step 1: Understand the terminologies
Before diving into the calculations, we should understand the key terms like cost of goods sold (COGS), gross profit, and net income.
COGS: This is the cost of producing or purchasing the goods that are sold during a specific period. Reducing the cost of goods sold will have a direct impact on the gross profit.
Gross Profit: This is the difference between revenue (total sales) and the COGS. Gross profit measures how effectively a company generates profit from direct labor and direct materials.
Net Income: This is the total profit remaining after deducting all expenses, taxes, and costs from the gross profit. The net income indicates a company's profitability and is an important measure for businesses to track over time.
Step 2: Establish the relationship between terminologies
There is a clear relationship between COGS, gross profit, and net income. As we reduce COGS, the gross profit will increase, and consequently, the net income will also increase. The formula to calculate net income can be given as:
Net Income = Gross Profit - (Expenses + Taxes)
Step 3: See the impact of better decisions on net income
When a business makes better purchasing and managing decisions, the COGS will likely decrease. A reduced COGS will lead to a higher gross profit. If the expenses and tax amounts remain the same, then the net income will naturally increase.
For example, let's assume a company has the following financial figures:
Revenue: $1,000,000
COGS: $700,000
Expenses: $200,000
Taxes: $50,000
Step 1: Calculate the Gross Profit
Gross Profit = Revenue - COGS
Gross Profit = \(1,000,000 - \)700,000
Gross Profit = $300,000
Step 2: Calculate the Net Income
Net Income = Gross Profit - (Expenses + Taxes)
Net Income = \(300,000 - (\)200,000 + $50,000)
Net Income = $50,000
Now let's assume that better decisions reduce the COGS by 10%, which is $70,000:
New COGS = \(700,000 - \)70,000
New COGS = $630,000
Step 3: Calculate the new Gross Profit
New Gross Profit = Revenue - New COGS
New Gross Profit = \(1,000,000 - \)630,000
New Gross Profit = $370,000
Step 4: Calculate the new Net Income
New Net Income = New Gross Profit - (Expenses + Taxes)
New Net Income = \(370,000 - (\)200,000 + $50,000)
New Net Income = $120,000
Step 5: Calculate the percentage increase in Net Income
Percentage Increase = (New Net Income - Old Net Income) / Old Net Income * 100
Percentage Increase = (\(120,000 - \)50,000) / $50,000 * 100
Percentage Increase = 140%
So, better decisions regarding purchasing and managing goods have caused a dramatic 140% increase in net income, highlighting the importance of improving these aspects of a business.
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