INCOME STATEMENT - Part 1

 Determining Gross Margin


Introduction

Income Statement Example

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


Introduction

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. 

  1. Creditors want to know if the company can pay back the loans.
  2. Investors want to know if the company will make a profit or not.

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.


Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


Income Statement Example

Beach Toys, Inc.


Transactions

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.


Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


The Value of 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

Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


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.


Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


 Homework:

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."

Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


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  

Top

Introduction

Transactions

Inventory Valuation

Gross Margin Calculation

Homework

Vocabulary

End


Copyright 1998-2005 by M. Susan Stiner. Created on June 20, 1998. Last modified: May 15, 2006 12:00 AM