Posted on Mar 25, 2014
Financial Statements Made Simple
Income Statements 101
Revenue & Cost of Goods Sold
Part 2 of 3
All Income Statements start with the good stuff….Revenues.
Revenues are the sales dollars generated from your normal course of business less any credits or returns.
Do you offer your customers an early paying discount?
If so, the total of all discounts taken are deducted from your sales total as well.
Here’s the calculation for Net Sales:
Done. Section one already explained!
The next section depends on your business type.
If you are in the service industry, your income statement will probably just show revenues and expenses.
If however, you are in the manufacturing or merchandising industries, you will have to deal with inventory.
Because of this, businesses in these sectors have an additional section called Cost of Goods Sold (COGS) on their Income Statements.
Here’s why…. when you purchase an item for resale it is recorded on the Balance Sheet in your inventory account.
The amount will sit in this account until such time it has been sold.
Once it’s been sold it becomes an expense and is moved to the income statement in the COGS section. This process matches the cost of the goods (now an expense) to the income it helped produce, this is called the matching principle; an accounting rule all businesses must follow.
The amounts that make up the COGS section will differ depending on your industry.
If you are in the merchandising industry the calculation typically looks like this:
Let’s explain each piece of the calculation….totally out of order!
At the end of the month, you’re going to have items left in your inventory that you didn’t sell; these items are called Ending Inventory.
The Ending Inventory of one period is the Beginning Inventory of the next period.
Total Purchases is the total amount of inventory bought in the month.
All this says is….you have so many dollars available to sell (beginning inventory + purchases). If an item wasn’t sold it will still be sitting in your ending inventory. So, if it’s still sitting in your inventory it has to be subtracted (cause we’re calculating the cost of goods sold, not the cost of goods not sold).
So, that’s how it works if you are a distributor. If you are a manufacturer, things get a tad more complicated.
If you sell merchandise, you simply buy and resell finished goods (wow, I made that sound simple huh?). However, if you manufacture, you have to produce the goods before you can actually sell them. Clearly, this involves a few more steps and, these steps need to be captured. So, you need to record all production costs in the COGS section.
All costs associated with producing the product (things like material, labour, repairs on machines used in production, and utilities directly related to the factory to name a few) need to be captured and recorded in COGS.
That’s one piece, now for the inventory piece….
Because production is an ongoing process, inventory in a manufacturing business will usually be in 1 of 3 forms.
1. It can be in the raw material form, where it has yet to be put into production
2. It could be at an in-between stage where it’s part way through assembly; this is called work in process
3. It can also be in finished form, where fabrication is complete and the goods are ready for sale
All this data is put into a Cost of Good Manufactured Statement (relax….we’re not going there), once this is done a COGS calculation can be completed.
When you compare the above COGS calculation to that of a distributor it’s really not that much different; the difference lies in the route getting there.
Whether you’re in the merchandising or manufacturing business the next step is the same. You take your Net Sales total and deduct your total Cost of Goods Sold to get your Gross Profit.
This total represents the money left to cover all remaining expenses like wages, utilities, and advertising for example.
A Gross Profit Margin (GPM) percentage is often calculated. This calculation involves dividing your Gross Profit total by your Net Sales total.
This tells you what percent of total sales is retained by the business. So, if your Gross Profit Margin is 40%, you would have .40 cents of every sales dollar left to pay other expenses. The higher your GPM the more money you’ll have left over.
What was your Gross Profit and GPM last month?
Go find out!!
A Profitable Boss = A HappyBoss