Exhibit 2–3 displays recent income statements, in highly summarized form and using the terminology employed by the companies, from Procter & Gamble, Southwest Airlines,
Costs on Financial Statements
Exhibit 2–1
Product Costs and Cost of Goods Sold
Year 1 Year 2 Time
Merchandise is acquired:
product cost is equal to the cost of purchase plus transportation cost.
Merchandise is sold:
expense called cost of merchandise sold (or cost of sales) is equal to the product cost identified with the merchandise sold.
Goods are manufactured:
product cost is equal to costs incurred in the manufacturing process.
Goods are sold:
expense called cost of goods sold is equal to the product cost identified with the goods sold.
At the end of Year 1, any inventory on hand is an asset, which is valued at its product cost.
Manufacturer Retailer or Wholesaler
Exhibit 2–2 Period Costs
Year 1 Year 2 Time
Period costs, such as selling and administrative costs, incurred in Year 1 are recognized as expenses in Year 1.
Period costs incurred in Year 2 are recognized as expenses in Year 2.
All period costs recorded as expense during year, so no asset to record at end of Year 1.
Period costs are treated the same way in all types of companies:
retailers and wholesalers, manufacturers, and service industry firms.
Learning Objective 2-3 Describe the role of costs in published financial statements.
PROCTOR & GAMBLE Statement of Income for a Recent Year Value
measured by product costs
Total net revenues ... $ 66,832 Cost of products sold ... 34,268 Gross profit ... $ 32,564 Selling, general, and administrative expense ... 18,853 Operating income ... $ 13,711 Interest and other expenses ... 385 Earnings before income taxes ... $ 13,326 Income taxes ... 3,465 Net earnings ... $ 9,861
WAL-MART STORES, INC.
Statement of Income for a Recent Year Value
measured
by product costs
Total revenues ... $500,343 Cost of sales ... 373,396 Gross profit ... $126,947 Operating, selling, general, and administrative expenses ... 106,510 Operating income ... $ 20,437 Interest expense and loss on debt ... 5,314 Income before income taxes ... $ 15,123 Provision for income taxes ... 4,600 Consolidated net income ... $ 10,523
SOUTHWEST AIRLINES CO.
Statement of Income for a Recent Year Operating revenue:
Passenger ... $ 19,141 Freight ... 173 Other ... 1,857 Total operating revenue ... $ 21,171 Operating expenses:
Salaries, wages, and benefits ... $ 7,319 Fuel and oil ... 3,940 Maintenance materials and repairs ... 1,001 Aircraft rentals ... 198 Landing fees and other rentals ... 1,292 Depreciation and amortization ... 1,218 Other operating expenses ... 2,688 Total operating expenses ... $ 17,656 Operating income ... $ 3,515 Other expenses (income):
Interest expense ... $ 114 Capitalized interest ... (49) Interest income ... (35) Other (gains) losses, net ... 234 Total other expenses (income) ... $ 264 Income before income taxes ... $ 3,251 Provision for income taxes ... (237) Net income ... $ 3,488
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Exhibit 2–3
Income Statements from Three Different Industries (all figures in millions of dollars)
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and Walmart. These companies are from three different industries and represent different ways that companies operate. Procter & Gamble, based in Cincinnati, Ohio, is a devel- oper and manufacturer of products in the consumer packaged goods (CPG) product seg- ment, with well-known brands that include Tide, Gillette, Pampers, Tampax, Pantene, Crest, Ivory, and Pepto-Bismol. Walmart, which does not manufacture its products, is a large retail firm with its headquarters in Bentonville, Arkansas, and retail operations around the globe. Southwest Airlines, a major air carrier based in Dallas, Texas, is a com- pany that does not manufacture or sell a tangible product but rather sells services.
Selling and administrative costs are always period costs on any type of company’s income statement. For example, Procter & Gamble lists $18.853 billion of selling, gen- eral, and administrative expense on its income statement in Exhibit 2–3.
For Procter & Gamble, the costs of manufactured inventory are product costs. All costs incurred in making finished products are stored as inventory cost until the time period when the products are sold. Then the product costs of the inventory sold become cost of products sold, an expense on the income statement.
Product costs for Walmart include all costs of acquiring merchandise inventory for resale. These product costs are classified as inventory until the time period during which the merchandise is sold. Then these costs become cost of sales (cost of goods sold).
There are no inventoried product costs at Southwest Airlines. Although this firm does engage in the production of air transportation services, its service output is con- sumed as soon as it is produced. Service industry firms, such as Southwest Airlines, JPMorgan Chase & Co., Sheraton Hotels & Resorts, Coldwell Banker Real Estate, and State Farm Insurance, generally refer to the costs of producing services as operating expenses. Operating expenses are treated as period costs and as such are expensed during the period in which they are incurred. Southwest Airlines includes costs such as employee wages, aviation fuel, and aircraft maintenance in operating expenses for the period.
Gross Profit and Operating Income Notice that the manufacturer and retailer income statements above include an item called gross profit, and all three income state- ments include a subtotal called operating income. These two views of profitability dif- fer from net income and are very important to managers and investors in understanding whether the company is successful in its core mission of producing and selling goods and services profitably.
Gross profit (sometimes called gross margin) is the portion of revenues left after deducting just the costs that have been classified as cost of sales (cost of goods/prod- ucts sold), without considering any other costs of operating the company. This profit number provides a view of profitability that is specific to the production process: how much money are we receiving for our goods and services after covering the costs of producing them?
Operating income (sometimes called operating profit) goes one step further to report the profit remaining from revenues after deducting both cost of sales and all period costs of operations. Operating income is a very important profit number for man- agers because it represents the profits resulting from operations, taking into account all costs of the operations but not the effects of financing (e.g., interest expense), taxes, or any other unusual business events. Why omit these items from operating income?
Because they are affected by many factors beyond just the process of producing and sell- ing goods and services: how the company chooses to raise the financing it needs, the tax strategy it follows, and unusual occurrences that are unrelated to regular operations. By omitting these items from operating income, we see a clearer picture of the profit earned from operating the core business of the company, which is the outcome most relevant for most managers.
Throughout this textbook, we will usually view a company’s profitability from the gross profit and operating income perspectives, and will discuss or compute net income only when we wish to consider the effect of taxes on a decision.
“A key focus is on the levers within our control to manage the pace of expenses.” (2b)
Google Inc.