A copy of Chapter x of the book, and a series of explanatory movies, can be accessed using the following links. Below is the full text of the Chapter and exercises.
There are three financial statements, indicated in the table below. This chapter will address the Income Statement, which tells us whether the business made money (profit) or lost money (losses) during the last financial period.
What is an Income Statement?
A income statement is a structured way of listing the revenue and expenses of the business for a specified period. It tells us not only whether there was a profit or loss, but the structure of the income statement also tells us important things that contributed to that result which can help us better manage the business in future.
Consider Movie Moments Ptd Limited, a business selling DVDs, drinks and popcorn in a rented store, which started two years ago by issuing $1,000 worth of shares to the sole shareholder and owner, John Smith.
We will now look at the Income Statement for the business for the last financial year, the year ended 30 June 2010.
Like the balance sheet, which had a specified structure (assets on the left, separated into current and non current), liabilites on the right (separated into current and non current) and then Owner’s equity, the Income Statement also has a specific structure.
First there is revenue, then we take off the costs associated with the items that we sold, then we take off all of the others costs of the business (like marketing and rent). We can see this structure in the Income Statement for Movie Moments for the last 12 months:
At the top: revenue
Revenue, sometimes called sales, is shown at the top of an Income Statement. This is the total of all of the sales made by the business during the period.
In the example above, Movie Moments sold $229,000 worth of DVDs, softdrinks and popcorrn.
Calculating the cost of the items sold
We know what the revenue from selling our goods was – but how much did those goods cost us?
The next part of the income Statement is directed towards calculating how much those goods cost, and is called “Cost of Goods Sold” which is commonly abbreviated to COGS.
Cost of goods sold (COGS) is a way to calculate the cost of the goods you have sold to your customers during the year.
At the end of the year, you know you have sales revenue in selling DVDs, of $10,000 – but how much did they cost you?
Working out COGS
At the beginning of the year, you know had $2,000 worth of DVDs in your store. (This is called opening stock, or opening inventory, or stock on hand 1/7/09)
At the end of the year, you have $3,000 worth of DVDs in your store. You know this because you actually count them all at the end of the year, and this is called a stocktake. Every business with inventory does this every year. (This is called closing stock, or closing inventory, or stock on hand 30/6/10).
The missing number you need in order to work out the cost of the DVDs you sold is the purchases of DVDs your business made during the year from your suppliers, together with any freight costs to get them to your store. (This is called purchases, stock purchases, inventory purchases or purchases from suppliers.)
If your supplier gave you a discount (called discount received), you deduct this from the purchases numbers to determine what they cost you. Note, outbound freight, sending your goods to customers, is listed within the “other expenses” in the income statement, and impacts net profit, not gross profit.
Doing the maths:
COGS = Opening stock + purchases – discounts received + inwards freight – closing stock
So, based on what you had at the beginning, and the DVDs you bought, that makes $12,400 worth of DVDs that you should have in the store.
But you now only have $3,000 in the store – which you know because you have physically conducted a stock take, and that is the number for inventory which is recorded on your balance sheet as at the end of the period.
The difference between these two numbers is the cost of the DVDs you sold.
The last element of calculating COGS is deducting the stock on hand at the end of the period, to work out the cost of the DVDs that you sold.
You sold $12,400 – $3,000 ie 9,400 worth of DVDs.
When you work this out, you would do it the following way:
Note that the negative numbers are in brackets.
Gross profit is revenue less the cost of goods sold, and appears on the income statement after the costs of goods sold calculation.
It is called Gross profit because it is before all of the other expenses of the business, like wages, rent, interest and the like have been deducted (which is then called net profit). Gross profit is called gross, or large, because it is always larger than net profit.
Gross profit can sometimes be called operating profit, because it is the profit that has been earned through the principal operations of the business.
A way to tell how profitable a business is from their operating activities is to look at the percentage that operating profit is of revenue – that is, how much of each dollar of revenue does the business keep as operating profit. For example, on sales of $10 million, and an operating profit of $1 million, that would be an operating margin of 10% because for every $10 in sales the company has made an operating profit of $1,
Operating margins are very different in different industries. For example, operating margins in pharmaceuticals, or Apple Inc are very high, whilst operating margins for construction companies are very low. When comparing the operating margins of companies, it is very important to compare those to other companies in the same industry.
Net profit and other expenses
Net profit is calculated by taking gross profit and then deducting all of the other expense of the business. Those expenses include wages, rent, interest, freighting the goods to your customers and the like. Unlike cost of goods sold, there is no calculation to be done in this part of the income statement – it is just a listing of all of the administrative, sales and marketing expenses which are totalled and then deducted from the Gross Profit number.
This is why net profit is always smaller than Gross profit – all of the expenses have been deducated by the time you get to Net profit, but only the cost of gods sold has been deducted in order to calculate Gross Profit.
In the same way that you can calculate operating margin to see what proportion of revenue is retained as gross profit, yiu can also create the net profit margin by calculating the proportion that net profit represents of revenue.
Taking the example above: on sales of $10 million, the business made an operating profit of $1 million. Other expenses were $500,000. This would mean that net profit would be $500,000, that would be mean operating margin of 5% because for every $10 in sales the company has made an operating profit of $0.5.
What about discounts to customers, or cancelled sales?
Many business will offer their customers discounts, either as part of a marketing promotion, or discounts are offered to encourage early payment of invoices. In either case, where an item is sold for $100, that full $100 would be counted as revenue for the business and appear at the top of the cinome statement.
Where a discount has been allowed to the customer, the business keeps track of all of the discounts, and then deducts those from the revenue number at the top of the income statement, which would then show:
Where a sale as been cancelled by the customer, this is known as a sales return. Again, the full value of the original sale will have been recorded in the revenue number that is displayed at the top of the income statement, so it is necessary to deduct the value of the sales that have been cancelled. Where sales returns have occurred, they are deducted from the revenue number at the top of the income statement in the following way:
In this way, the revenue number at the top of the income statement is an accurate reflection of the revenue that the business has earned, taking proper account of any discounts offered to customers, and any sales returns that have occurred duing the year.
What about other revenues that may arise?
Sometimes a business will earn revenues through doing things other than selling their products. For example, a business that manufactures cars may sell a factory, or sell real estate that it no longer needs.
If the revenue from this transation is included at the top of the income statement, then the operating profit would not tell us the profit that has been made on the sale of the companies goods – because it has been polluted with the information about the revenue from the property transation. For this reason, any non operating revenues, where they arise in the business for the year, are added after gross profit and before deducting the other expenses of the business for the year. The subtotal heading after adding such a non operating expense would be Gross Profit rather than operting profit.
All of the above elements are address in the review of income statments video.
- What is an Income Statement?
- What is the difference between gross profit and net profit on an Income Statement?
- What is deducted from revenue to arrive at gross profit?
- What is the formula for cost of goods sold?
- In what of the Income Statement would you find freight outwards?
- What is non operating income, and where is it found on an Income Statement?
- What is operating margin?
- Calculate cost of goods sold with the following information.
- Prepare an income statement from the following information.