The Income Statement (Sections 2.4 - 2.6)

Cost of Goods Sold (COGS) or Cost of Sales (COS)

A company’s direct cost of manufacture (for manufacturers) or procurement (for merchandisers) of a good or service that the company sells to generate revenue.

NOTE: Remember the matching principle! Not all of these costs are going to be immediately recognized.

(Slide 79 / 315)

List 5 examples of COGS.

Merchandise inventory ; manufactured goods inventory (raw material costs, direct labor costs, factory overhead) ; shipping and delivery costs ; any other costs directly associated with the generation of revenue ; depreciation of fixed assets

(Slide 79 / 315)

What are examples of costs that are not classified as COGS?

• Administrative costs

  • Corporate overhead, marketing & administrative expenses, R&D, and salaries of employees not directly associated with the manufacture/procurement of a good or service

    • included under Selling, General & Administrative (SG&A) Expenses or other line items

(Slide 80 / 315)

Practice: Calculate the gross profit for this tire manufacturer using the following information.

• Tire producer recorded $100m in net revenues in 2015 to 8,000 customers.

• In 2015, the tire producer purchased $60m in rubber raw materials.

• In 2015, the tire producer spent $7m on factory overhead.

• In 2015, the tire producer spent $5m on direct labor.

• $40m in tire inventories were used up in the sales that generated $100m in tire revenue, which were comprised of $30m in raw materials costs, $5m in factory overhead, and $5m in direct labor.

• In 2015, the tire producer spent $2m in shipping costs.

• In 2015, the tire producer spent $4m for office supplies.

• In 2015, the tire producer spent $2m on R&D for a new rubber technology.

NOTE: Gross profit = Net revenues - COGS

Net revenues = $100m

COGS = $40m + $2m = $42m

Gross profit = $100m - $42m = $58m

Remember the matching principle: it doesn’t matter how many new inventories were purchased—only that they’re used up in generating revenue.

(Slides 87-88 / 315)

Selling, General, & Administrative (SG&A) Costs

Operating expenses that are not included in COGS (i.e. not directly associated with the manufacture/procurement of goods/services used to generate revenue).

(Slide 89 / 315)

List 5 examples of SG&A.

A store lease expense for a retail business ; salaries and commissions of salespeople and cashiers ; marketing and advertising expenses ; administrative, IT, and office support staff ; equipment used for selling (e.g. a cash register) ; executive salaries ; legal expenses

(Slide 89 / 315)

Research & Development (R&D)

Stem from a company’s activities directed at developing new products or procedures. It’s often identified on a separate line of the IS, but depending on the company, R&D is allocated within Other Operating Expenses or SG&A.

(Slide 94 / 315)

What industries have R&D make up a large component of their expenses?

Healthcare, energy, technology, etc. (e.g. Google, Microsoft, Exxon Mobil, Apple, Pfizer)

What is included in R&D expenses?

Compensation for employees, equipment, and facilities engaged in the R&D process.

(Slide 94 / 315)

Depreciation (Expense)

Quantifies the wear and tear (from use and passage of time) of the physical asset through a systematic decrease (depreciation) of the assets’ book (historical) value.

NOTE: Land is a fixed asset, but is NOT depreciated.

(Slide 98 / 315)

Where is Depreciation on the Income Statement?

There is no line on the IS identifying depreciation expense. Instead, it is included within COGS or SG&A depending on whether the asset being depreciated is directly tied with manufacture/procurement or tied to something not directly associated with manufacture/procurement.

NOTE: Depreciation is noted on the cash flow statement.

(Slide 101 / 315)

Depreciation is a __________ expense. Since this is the case, the IS is not a reliable tool for tracking a company’s cash position.

non-cash

(Slide 103 / 315)

Under US GAAP and IFRS, most companies choose to depreciate assets evenly over their useful lives. The method of depreciation is called the ___________. Under this method, the annual depreciation expense is calculated as follows: ____________.

straight-line method ;

(original cost - salvage value) / useful life

• Original cost = original cost/book value of the asset

• Salvage (residual) value = the asset’s estimated salvage (or disposal/residual/trade-in value) at the time of disposal

• Original cost - salvage value = depreciable cost

• Useful life = total years the asset is expected to remain in service

(Slide 106 / 315)

While most companies choose straight-line depreciation, under both US GAAP and IFRS, companies are allowed to use accelerated depreciation methods, which calculate a ________ amount of depreciation in earlier years than later years. Companies generally prefer _________ because it recognizes _________ depreciation in earlier years than ___________. Lower depreciation expense will result in an IS that shows higher profitability.

higher/greater ; straight-line depreciation ; lower ; accelerated depreciation

(Slide 109 / 315)