called gross profit, seeks to calculate the profitability of a company’s operations after direct costs. Its ultimate goal is to determine the company’s gross margin.
For example, if you’re a self-employed window washer, your margin is all the money you make for washing windows, minus the cost of the materials you used to wash those windows (for example, soap, water, and other supplies), but not the cost of your ladder because you use it over and over again.
Net sales
Net sales is all the money that a company makes from its primary operations. If the company is a retailer, then net sales includes all the money the company generates from selling retail goods. If the company is a lawn service but it also offers tree trimming, then net sales includes the money it makes from both services. However, it doesn’t include any money made from other activities outside of its core operation(s). So no counting the extra money made from selling an old lawnmower.
To get net sales, don’t subtract any costs yet. Net sales includes every last dime a company makes from sales; the costs come into play later.
Cost of goods sold
To make a product or provide a service, a company has to purchase supplies. Maybe a tool manufacturer needs to buy steel. Maybe a window washing company needs to buy soap and water. Maybe a tutoring company just needs to pay its tutors. No matter what its primary operation is, every company adds up all the direct costs it incurs as a result of actually making its product or service, not including indirect costs (sales costs, administrative costs, research costs, and so on), and includes them under cost of goods sold (COGS) on the income statement. The very nature of this section lies within its name: It’s the cost a company has incurred in making or buying the goods that it has sold.
Just like the price of beer changes at the store from time to time, the costs of those things a company purchases can change. So when the things a company purchases change, it must choose how it will measure the cost of goods sold. The two primary ways a company can account for the costs of goods sold are
FIFO (first-in, first-out): With this method, a company will use the costs of those things it purchased earliest when accounting for COGS. In other words, the first inventory made or bought is the first inventory to be sold.
LIFO (last-in, first-out): With this method, a company will use the cost of those things it purchased most recently when accounting for COGS. In other words, the most recent inventory made or bought is the first inventory to be sold.
Gross margin
The last part of the gross profit portion of the income statement is the gross margin, which you get by subtracting the cost of goods sold from the net sales. The gross margin is all the money a company has left over from its primary operations to pay for overhead and indirect costs, like the sales staff, building rent, janitorial services, and everything else that’s not directly related to the production or purchase of inventory.
When you divide gross margin by net sales, you get the percentage of net sales that isn’t spent on producing the inventory. This percentage is extremely important in evaluating a company’s ability to fund supporting operations, plan growth, and create budgets. The gross margin, sometimes called just margin, also comes into play in a number of metrics that I describe in Chapters 7 and 8.
Operating income
The next portion of the income statement takes into account the rest of a company’s costs of doing business (other than the costs of goods sold) and is called operating income. Think of it as a way of breaking down the overhead costs associated with all the standard operations without including any infrequent revenues or costs. The overall goal of the operating income is to determine how much money a company is making after taking into consideration all the costs the company incurs during its primary and supporting operations. Here’s what goes into the operating income:
Selling expense: This includes everything a company spent on selling the products it bought or made, such as advertising, sales wages or commissions, shipping, and the cost of retail outlets. The cost of opening a retail outlet may be a selling expense, or perhaps just the cost of a sales team may be a selling expense — anything at all related or attributed exclusively to the sales process, whether entirely or in part.
General and administrative costs: Also called G&A costs, these cover all the expenses of running a company. The salaries of the finance, marketing, human resources, and management staff fall into this category, as do the salaries of everyone who isn’t directly associated with making or selling the inventory. Other costs that fall into this category include the costs of buildings, utilities, office supplies, insurance, office equipment, decorations, and a wide variety of other stuff. Any time a company spends money on an expense that keeps the company going but that isn’t related to production or sales, it goes into the G&A costs.
Depreciation and amortization: The income statement includes a section for depreciation and amortization, but it doesn’t reveal anything about a physical transition of money from one party to another. Rather, this section simply recognizes the use of items that will lose value. The amount of depreciation listed on the income statement is the same as the amount incurred during a single period that gets added to the balance sheet.
To get the operating income, you just add up all the costs listed in the preceding three sections and then subtract that number from the gross margin. Because the operating income represents the amount of money a company has left over after it has paid for all its standard operations, companies need to consider it when planning whether to expand, whether to use equity or debt to fund expansion, and how much money they can borrow and safely pay back using their primary operations. Operating income is also useful in other metrics, such as liquidity, which I cover in Chapter 7.
Earnings before interest and taxes (EBIT)
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