Determining Gross Margin
The Income Statement is the statement that shows:
| Revenue | |
| Less: | Expenses |
| Equals: | Net Income or Loss |
In the U.S., we show losses with brackets < > or parentheses ( ), so
| Revenue | |
| Less: | Expenses |
| Equals: | Net Income (Loss) |
Expenses are divided into two groups: cost of goods sold and operating expenses.
Cost of Goods Sold is the price the company paid for the
product that the company sells.
"Goods" and "Inventory" are other names
for the product that the company sells.
"Cost of Revenue" is another name for
cost of goods sold.
The Cost of Goods Sold is calculated this way:
| Beginning Inventory | |
Plus: |
Purchases |
Less: |
Ending Inventory |
Equals: |
Cost of Goods Sold |
Operating expenses are the daily expenses of the business,
except for cost of goods sold.
Operating expenses exclude: (1) cost of goods sold, (2) interest expense,
(3) tax expense and (4) capital expenditures.
Next week we will talk more about operating expenses.
Gross margin is revenue less cost of goods sold. Another name for gross margin is "gross profit."
Gross margin is calculated this way:
| Revenue | |
| Less: | Cost of Goods Sold |
| Equals: | Gross Margin |
When a company sells a product, the company must know the gross
margin from that product.
Gross margin is a very important number.
Gross margin is the revenue available to meet (pay) the operating expenses.
The net income comes from the gross margin.
In the end, the net income is the revenue left over after the company meets
(pays) cost of goods sold expense and operating expenses.
Profitability is the ability of a company to have more revenue than expenses.
It is important to measure profitability for two reasons.
The size of gross margin compared to revenue is the first measure of profitability.
High gross margin means high profit potential. Low gross margin means low
profit potential.
This is the usual form of an income statement in the U.S.:
| Revenue | |
Less: |
Cost of Goods Sold |
Equals: |
Gross Margin |
Less: |
Operating Expenses |
Equals: |
Net Income (Loss) |
Next, we will develop the first part of the income statement for Beach Toys, Inc. We will develop revenue, cost of goods sold and gross margin.
During February, Beach Toys had the following transactions. Beach Toys bought inventory three times. Beach Toys made one sale. Beach Toys paid for part of its inventory.
Transaction |
||||
number |
type |
units |
amount per unit |
total amount |
5 |
credit purchase | 100 |
$100 |
$10,000 (100 x $100) |
6 |
credit purchase | 100 |
$120 |
$12,000 (100 x $120) |
7 |
credit purchase | 100 |
$150 |
$15,000 (100 x $150) |
8 |
credit sale | 100 |
$300 |
$30,000 (100 x $300) |
9 |
cash payment of invoice #1 | 100 |
$100 |
$10,000 (100 x $100) |
When these transactions are recorded in a journal, the entries are:
Transaction |
Account |
Debit |
Credit |
| To record the first credit purchase of inventory: | |||
5 |
Inventory | $10,000 | |
Accounts payable |
$10,000 | ||
| To record the second credit purchase of inventory: | |||
6 |
Inventory | $12,000 | |
Accounts payable |
$12,000 | ||
| To record the third credit purchase of inventory: | |||
7 |
Inventory | $15,000 | |
Accounts payable |
$15,000 | ||
| To record the cost of the inventory sold: | |||
8A |
Cost of Goods Sold | $10,000 | |
Inventory |
$10,000 | ||
| To record the credit sale: | |||
8B |
Accounts Receivable | $30,000 | |
Sales |
$30,000 | ||
| To record the payment of the invoice for the first inventory credit purchase: | |||
9 |
Accounts Payable | $10,000 | |
Cash |
$10,000 | ||
Next, we will see that the amount of cost of goods sold shown in
transaction 8A can change.
The amount of cost of goods sold (transaction 8A) depends on how we value the inventory.
There are several ways to value inventory. We will look at two ways to value inventory.
Look again at how to calculate the cost of goods sold.
The value of the inventory sold (the cost of goods sold) depends on
| 1 | the value given to beginning inventory, |
| 2 | the value given to ending inventory and |
| 3 | the cost of the inventory purchased during the period. |
Under US GAAP there is one way to value the purchase of inventory: historical cost. Purchases are valued (recorded) at the amount billed at the time of purchase. We ignore shipping costs in this course.
However, US GAAP allows us to value the beginning and ending inventory in several ways. Two of the ways are FIFO and LIFO. A pronunciation guide: FIFO and LIFO rhyme. LIFO sounds like "life-oh."
A company may use any US GAAP method to value inventory. But it must use the same method to value both beginning and ending inventory. US GAAP does not let a company use one method to value beginning inventory and another method to value ending inventory.
FIFO
FIFO is an abbreviation for "First-In, First-Out." This means that the cost of the oldest inventory (First-In) is used as the cost of goods sold. This also means that the cost of the ending inventory is the cost of the newest purchases.
FIFO is better to use when prices fall. When prices fall, the first purchase costs more than the last purchase. The cost of goods sold is relatively high, because the early inventory is the most expensive. Net income is lower. Therefore, income tax expense is lower.
LIFO
LIFO is an abbreviation for "Last-In, First-Out." This means that the cost of the newest inventory (Last-In) is used as the cost of goods sold. This also means that the cost of the ending inventory is the cost of the oldest purchases.
LIFO is a better method to use when prices rise (inflation). When prices rise, the last purchase costs more than the first purchase. The cost of goods sold is relatively high, because the most recent inventory is the most expensive. Net income is lower. Therefore, income tax expense is lower.
This is a sample of inventory valuation methods that real companies use:
| Company | Financial Statement Date | Method | Statement Source |
| Dell | FYE January 28, 2005 | FIFO | page 40 of SEC filing |
| Kodak | FYE December 31, 2004 | LIFO (most US inventories) FIFO (all other inventories) |
Financial Statement Notes 1 & 3 |
| Macromedia | FYE March 31, 2005 | FIFO | scroll to page F-12 of the SEC filing |
| Nike | FYE May 31, 2004 | FIFO | scroll to page 40 of the SEC filing |
| Patterson Companies, Inc | FYE April 24, 2004 | FIFO (domestic dental & veterinary inventories) LIFO (all other inventories) |
page 35 of SEC filing |
Partial Income Statement - Gross Margin Calculation
The first part of the income statement is a calculation of gross margin.
This is the calculation of gross margin for Beach Toys for the month ended March
31, 2005.
Beach Toys uses FIFO to value inventory.
Beach Toys, Inc. |
||
Gross Margin Calculation |
||
For the month ended March 31, 2005 |
||
| Revenues | $30,000 | |
| Cost of Goods Sold: | ||
| Beginning Inventory | $ - 0 - | |
| Purchases | 37,000 | |
| less: Ending Inventory | 27,000 | |
| Cost of Goods Sold | 10,000 | |
| Gross Margin | $20,000 | |
This is the first part of the income statement. In the next lesson, we will finish the income statement.
| 1. | What is the format for an American Income Statement? |
| 2. | Use your words to tell me how to calculate cost of goods sold. You do not need to use any numbers. |
| 2. | Did Beach Toys use LIFO or FIFO to calculate the cost of goods sold? |
| 3. | Does the purchase price of inventory rise or fall for Beach Toys, Inc? |
| 4. | Which inventory method (LIFO or FIFO) is better for Beach
Toys, Inc to use? "Better" means "results in lower income tax." |
Vocabulary - Income Statement (Part 1)
| English | Japanese |
| cost of goods sold | |
| first-in, first-out | |
| gross margin | |
| inventory | |
| invoice | |
| last-in, first-out | |
| net income | |
| purchase | |
| revenue | |
| sale |