Answer to self-test question
2.3 Calculating the gross profit
2.3.1 Revenue
The first item shown on the income statement is the revenue. This is the amount to be received from customers in return for the provision of Example’s goods or services. As soon as a sale is made it is shown in the income statement, even if the money has not yet been received from the customer. Other terms used instead of ‘revenue’ include ‘sales turnover’ or ‘sales income’.
You may be starting to appreciate how a company can be showing a profit in its income statement but still have no cash.
The issue of revenue recognition refers to the point in time at which a particular item of revenue can be shown in an income statement. If you think for a moment about the question in the following exercise you will begin to see why this might be an important issue.
Exercise
The J Company manufactures precision measuring equipment to individual customers’ specifications. Certain details relating to an order from customer C are as follows.
Enquiry received from customer 11 March Quotation supplied to customer 17 March Quotation accepted and order confirmed 27 March Manufacturing of equipment completed 30 March Equipment despatched to customer 2 April
Invoice sent to customer 10 April
Customer pays first of three instalments 10 May Customer pays final instalment 10 July
At what date should the J Company recognise (i.e. show in the income statement) the revenue earned on this order?
Accounting in a Nutshell
30 In this exercise the revenue was recognised in the income statement before the cash was actually received from the customer. Sometimes the issue of revenue recognition works the other way round. The revenue might have been already received from the customer but it cannot yet be recognised in the income statement.
For example the annual report of the Vodafone Group plc, the mobile communications company, for the year ended 31 March 2005 contains the following statement.
Revenue from the sale of prepaid credit is deferred until such time as the customer uses the airtime, or the credit expires.
The revenue received is deferred, that is not shown in the income statement, until the customer uses the airtime. Thus the revenue earned will be correctly matched with the costs of providing the airtime, in the income statement of a future period when the service is actually used. If the customer does not use the service, that is the credit expires, there will be no future costs against which to match the revenue and it can therefore be recognised as revenue at that point.
Solution
It has taken almost four months for all transactions to be completed in respect of this particular order and we have potentially at least eight different dates on which we could recognise the revenue earned.
The general rule is that revenue is recognised when all of the following criteria have been fulfilled:
◆ The J Company has transferred to the customer the ownership and control of the equipment
◆ The revenue from the order can be measured reliably
◆ The customer has recognised its liability and indicated its willingness to pay for the equipment.
The date on which these criteria are all fulfilled is 2 April.
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Accounting in a Nutshell
By now you should appreciate that the £5,590,000 shown as revenue on Example plc’s income statement is almost certainly not the amount of cash that has been received from customers during Year 7. Rather, it is the amount of revenue that has been recognised in respect of the goods sold or services supplied to customers during the year.
2.3.2 Cost of sales
The cost of sales is deducted from the revenue recognised. This is the cost of the goods or services that have been sold to generate the revenue for the period.
An alternative term used to describe cost of sales might be ‘cost of goods sold’.
The cost of goods sold is most easily derived for a manufacturing company. For example, in a company which manufactures washing machines it is the actual cost of producing the machines for sale:
the materials used, the wages paid to manufacturing labour, the overhead cost of running the factory, etc.
Another term which may be used to describe this type of cost is ‘direct cost’. We will return to consider direct costs in a later chapter.
The cost of goods sold would not include ‘support costs’ such as advertising and head office secretarial costs. These would be included later in the income statement.
It is also fairly easy to derive the cost of sales or cost of goods sold for a retailing organisation such as a supermarket. In this case it would probably be the amount paid to the supplier for the goods to be sold to the supermarket’s customers, plus distribution costs and store operating costs.
It is not so easy to derive the cost of sales for a service organisation.
For example, for a haulage company the cost of sales might be the actual costs of providing the haulage service to the customer, including fuel costs and drivers’ wages. It would not include support costs such as those mentioned earlier.
Accounting in a Nutshell
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2.3.3 Gross profit
This is the first measure of a company’s profit which is calculated by deducting the cost of sales from the revenue. It shows whether the company sold its goods and services for more than they cost to provide. You can see that if a company does not make a gross profit then it is really in trouble! It is the gross profit that is used to pay all the other expenses of running the business.
Another term used to describe gross profit is ‘gross margin’.