The installment method of sales allows customers to make regular payments after receiving a product or service. Companies offer this option to encourage customers to shop at the company rather than at its competitors. Businesses that sell to customers through the installment method recognize only a portion of the gross income each year.
Calculating only a portion of the gross income throughout the installment period involves reporting the income fairly. Installment plans carry the risk that customers will default on their payments. As the length of the installment term increases, the risk of customer default also increases. When customers default, the company loses the income from all future payments. The company recognizes only a limited amount of gross income to reduce the impact of a customer default.
Determine Total Cost
The company needs to know the total cost of the sale before it can determine the gross income. If the company sells a product, it determines the manufacturing cost of the product by adding the material, labor and overhead costs. If the company sells a service, it determines the total cost of the service by adding the labor and overhead costs and any material costs that apply to the service.
Determine Total Revenue
The company also needs to determine the total revenue expected from the job. The company uses the selling price agreed to by the customer as the total revenue.
Calculate Gross Income Percentage
To calculate the gross income from an installment sale, the company first determines the gross income percentage. The company subtracts the total cost from the total revenue to calculate the anticipated total gross income from the sale. The company then divides the total gross income by the total revenue from the sale. This determines the gross income percentage.
Calculate Annual Gross Income
The company calculates the annual gross income using both the gross income percentage and the amount of money collected from the customer throughout the year. The company multiplies the payments received by the gross income percentage. This provides the gross income for the year. For example, consider a customer who purchased $5,000 in merchandise and enters into an installment agreement to pay for it at a rate of $1,000 per year. The company's cost of the merchandise is $3,000. The company calculates the gross income by subtracting that $3,000 from the selling price of $5,000 to equal $2,000. The company calculates the gross income percentage by dividing the gross income of $2,000 by the selling price of $5,000. The result is 40 percent. At the end of the year, the company receives its payment of $1,000. The company multiplies this payment by the gross income percentage of 40 percent to arrive at a gross income of $400 for the year.
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