If you are interested in working in accounting or finance, it is helpful to know the common term 'revenue'. Learning what revenue means can help you determine your company's financial health. Understanding the types of revenue can also help you guide your company in making strategic financial decisions. In this article, we explain what is revenue, examine its importance, list the different types of revenue and review five revenue recognition methods.
What is revenue?
Revenue is the income a business earns by selling goods or services to a customer. It is typically a key indicator of a company's financial health. A company's revenue may include:
- Sales of goods or services
- Rental income
Evaluating your company's revenue can help you determine how well the business is performing compared to previous years. Revenue can also assist your company in recognising which products or services customers prefer. This can improve the company's product development process, which may further increase the revenue it earns.
Why is understanding revenue important?
If you work in finance or accounting, it is helpful to understand revenue in order to accomplish tasks at work accurately. Some professionals analyse revenue data to develop pricing strategies, create short-term and long-term financial goals and establish a budget for a project. They may also refer to that data when preparing income statements. For example, if you are an accountant, you may record your company's revenue on the first line of an income statement for a particular period. Learning about your company's revenue can also help you predict its growth potential, which may affect your career goals.
Revenue vs. profit
There are three key differences between revenue and profit:
- What each value means: revenue refers to the income a company earns by providing services or selling products in a given financial year. In comparison, profit refers to the amount realised by a company after subtracting the expenses it incurred when providing a service or goods from the total revenue.
- Where each value appears on an income statement: revenue typically appears on the first line of an income statement. In contrast, profit usually appears on the bottom line of an income statement.
- How companies refer to each term: some companies use the term 'net income' rather than 'profit'. When referring to revenue, some companies use the term 'sales'.
2 types of revenue
Here are the two main types of revenue:
Operating revenue is the income a company earns by conducting its core business operations. It is typically a company's largest source of income. For example, a hospital might earn its operating revenue by providing medical services, while a retail store could produce its operating revenue by selling merchandise. Depending on the business and industry, a company's operating revenue may include various elements. Some examples of operating revenue are:
- Sales revenue: a sale occurs when there is an exchange of goods for currency. For example, a fashion company that sells clothing could record clothing sales as revenue.
- Service revenue: service revenue occurs when a company or consultant provides professional services to a client. For example, a marketing firm may record the revenue it earns from providing marketing services to its clients.
Nonoperating revenue is the income a company earns by conducting business outside of its core business operations. Some examples of nonoperating revenue are:
- Rent revenue: rent revenue is the income a company earns from allowing third parties to rent buildings or equipment.
- Interest revenue: this is the income a company earns from an investment. Interest revenue can also include the interest accrued from accounts receivable.
Examples of revenue
Here are some examples of revenue that a company may earn:
Gross revenue, or gross sales, is the total income your company earns during a particular accounting period, without prior deductions. It can show a company's ability to sell its goods and services effectively. Gross revenue typically appears on the top line of an income statement.
To calculate gross revenue, you can use this formula:
Revenue = price of goods or services × number of units sold or number of customers
For example, if a company sells 10 computers at ₹50,000 each, it could use this formula to calculate its gross revenue:
Gross revenue = ₹50,000 × 10 = ₹500,000
Net revenue, or net sales, refers to the value of a company's revenue after subtracting discounts, item returns and business costs such as commissions.
To calculate net revenue, you can use this formula:
Net revenue = gross revenue - commissions - discounts - returns
For example, if a company earns a gross revenue of ₹500,000 for selling 10 computers, offers its sales representatives a total of ₹50,000 in commissions, provides its customers with a discount of ₹10,000 on each computer and receives no returned items, it might use the following formula:
Net revenue = ₹500,000 – ₹50,000 – (₹10,000 × 10 computers) − ₹0 in returns = ₹350,000
Accountants use both gross and net revenue to summarise their company's financial health and evaluate the performance of the company in terms of profit and expenses.
Deferred revenue, or unearned revenue, is the income a company earns before providing services or goods to a customer. It is an advance payment the company receives for products or services that it plans to deliver in the future. As your company delivers goods or services, a portion of its deferred revenue becomes its earned revenue.
Accrued revenue is the revenue a company earns for delivering goods or services that a customer has not paid for yet. It is the revenue that a business recognises but has not yet realised. Accrued revenue is significant because it can help accountants understand their company's long-term financial performance and review how sales contribute to the company's profitability and long-term growth.
5 revenue recognition methods in accounting
Revenue recognition is an important accounting principle that outlines specific conditions under which a company recognises different types of revenue and determines how to represent the revenue in financial statements. The method your company chooses depends upon the industry in which you operate and business circumstances. The five revenue recognition methods are:
Cost recovery method
In the cost recovery method, a business recognises a profit related to a sale after a customer pays for the goods or services sold. Your company may use this approach to clarify its total expenses for completing a project related to the good or service sold, such as product development. The company can then use this information to develop accurate budgets for similar projects in the future.
If your company gives customers the option to pay for a product over multiple years, it may use the instalment method of revenue recognition. Companies that sell high-cost goods or services often use this method. A company may also use this method to expand its audience by providing customers with a cost-effective way to purchase a product.
A company may use the sales-basis method if its customers make a purchase and it delivers the goods or services its customers bought. Companies that apply the sales-basis method typically transfer the ownership of a product to the customer at the time of sale. The retail industry widely uses the sales-basis method of revenue recognition.
Percentage of completion method
Companies use the percentage of completion method when a project lasts several years. Companies that build aeroplanes, ships or bridges may take more than a year to deliver the final product. During that time, a company can show its shareholders that it is generating revenue and profits before completing the project. By using the percentage of completion method, your company can report profit or loss related to a project in every financial year in which the project is active.
Completed contract method
A company that uses the completed contract method often recognises the revenue it has earned from a project after the project is finished. If your company uses this method, it may create a contract and ask a client to agree to specific terms to determine when work on the project is complete. Usually, the construction industry or other industries that involve project-based contracts use the completed contract method.