Answer to self-test question
2.4 Calculating the profit for the period
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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’.
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However, the allocation of expenses to individual functions requires the use of some judgement because many resources are shared by more than one function. Therefore the final figure for the total cost incurred by each function can be rather arbitrary.
Consequently when this classification is used companies often disclose additional information in the notes accompanying the income statement. This additional information provides detail about staff costs, depreciation expense, etc.
In the next chapter we will discuss the depreciation expense in more detail and look at how it is calculated.
2.4.2 Accruals and prepayments
Whichever way the expenses are classified, it is not simply a case of picking up the expenditure balances from the accounts and showing them as the costs for the year. We have seen that the cost shown in the income statement must be only the cost that relates to the year. Therefore we have to adjust for any items paid in advance (prepayments) or for any bills that are still unpaid or owing (accruals).
For instance, if Example has paid its insurance bill for the period up to the end of March Year 8 then it would not be fair to charge all of that insurance cost as a cost of running the business in Year 7.
This would overstate the cost for Year 7 and understate the cost for Year 8. The amount of the insurance that relates to January, February and March Year 8 is deducted from the insurance balance and only the remainder is shown as the insurance cost for Year 7.
Furthermore, Example may have paid its latest head office telephone bill on 30 November Year 7. To be able to include a fair telephone cost for the period it will be necessary to estimate the telephone cost for December and add this on to the amount paid so far. Can you imagine how difficult it is to produce an accurate estimate? It is hard enough to estimate what your own telephone bill will be for the next quarter, but when you are estimating for dozens or even hundreds of telephones and data processing lines the task is extremely difficult.
In the next chapter we will see what happens to the part of the insurance bill that has been deducted (the prepayment) and to the extra that has been added to the telephone bill (the accrual).
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For other types of accrual such as a newspaper advertisement that is still to be invoiced, the accountant often needs to rely on the relevant manager informing the accounts department when invoices are still expected. Those readers who are or who work for budget managers might now appreciate why the accounts department asks them for their accruals at the end of each period.
The amount of £890,000 shown in Example plc’s income statement is therefore not simply the total of the balances shown on the company’s accounting records. The amounts paid during the year will have been adjusted (albeit often subjectively) to arrive at the best possible estimate of a true and fair cost for the year.
Another subjective item included within the various cost classifications is depreciation. We shall see what this is and how it is calculated in the next chapter.
Attempt the following exercise to adjust for accruals and prepayments. Do not worry if you get it wrong or if you are not quite sure how to begin. The main thing is to ensure that you understand the solution and the reason for the adjustments before reading on.
Exercise
A company rents its office photocopier. The basic rental payments are made in advance and in addition at the end of each quarter the company pays 2 pence per copy made during the last quarter. The latest invoice for photocopier expenses was paid on 31 March. Relevant information is as follows.
◆ Latest rental payment made on 31 March: £90 for the quarter ended 30 June
◆ Number of photocopies taken, 1–30 April9,800
◆ Photocopier charges account balance as at 30 April£2,700 What is the correct cost for photocopier charges to be included in the company’s income statement for the period ended 30 April?
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2.4.3 Profit before interest and taxation
Another term used to describe this profit measure is operating profit. It is calculated by adding back the interest cost to the profit before tax. If we assume that Example plc’s finance costs of £50,000 consist entirely of interest paid on borrowed funds then Example plc’s operating profit is £650,000 (£600,000£50,000 interest).
Later in this book we will see that this is a very important profit measure because it is the profit over which operational managers can exercise day-to-day control. It is the profit measure which they can most easily influence because it is not affected by factors such as taxation and interest which are largely outside their control.
2.4.4 Taxation
Companies pay corporation tax, also referred to as income tax, on their profits. It is outside the scope of this book to examine the taxation charge in any detail but basically companies pay taxation at a very similar percentage rate to that paid by individuals.
However, there are many adjustments which must be made to the profit figure in order to calculate the company’s taxable profit.
These adjustments will be discussed with HM Revenue and Customs before the final taxation charge is agreed.