Income Statement Terms

We will define the terms used in the Income Statement. Refer back to the sample income statement as you read these explanations.

Revenue refers to the dollars coming into the company from sales of products or services. This is a crucial number to any company. If a company cannot manage to sell enough stuff, eventually it will have to go out of business. The term almost always refers to a dollar amount before any expenses are deducted. Other sources of income, such as the interest a company earns or the sale of a company it owns (subsidiary,) are not usually referred to as revenue, or they are shown separately from sales revenue. This is because sales revenue needs to be measured on its own, not distorted by other income. Sometimes revenue is shown separately for individual products or product lines. Revenue received is compared to corporate revenue goals and to previous financial periods, as in our example. The term sales, or sometimes net sales, may be used interchangeably with the word revenue.

Costs are deducted from this revenue figure. An income statement includes many different kinds of costs, but the cost of sales is an important one. In our income statement example, the cost of sales would include all the raw materials that went into the making of a product and all wages paid to produce it. In our example, the cost of sales includes only what it cost to make it, not what it cost to sell it. It seems confusing, since the word sales is part of the term, but it refers to the cost of the product which was sold. These are also referred to as direct costs, since these costs would not be incurred if the product were not being manufactured. Somehow, we need to determine how much it cost us to produce our products or a specific product line. Only then can we begin to determine if it is profitable.

At this point, let's consider cost in general. Cost is usually an extremely complex concept. There are certified public accountants who specialize in cost accounting. You will appear very naive if you assume that the cost a company incurs for its product or service is cut-and-dried.

Consider this example: You have just spent $3 million to develop a new type of contact lens. You need a $500,000 machine to manufacture it, and the materials to make it cost $0.04 per pair from the plastics manufacturer. What is your cost for these lenses? What price should you charge? Legally there may be different ways to determine cost. Two companies with the same sales and expenses can make and show varying amounts of profit on specific products or product lines, depending on how they cost their goods or services on paper.

Determining costs may be easier for retailers than for manufacturers, since retailers are charged a certain amount for the merchandise they receive from wholesalers and distributors. If you are a retailer, however, how much does it cost you to carry this item in inventory? How much did you pay for the money (interest) to buy from the wholesaler? What other items are you not buying because you have your money tied up in this merchandise?

How does cost compare to price? Consider our contact lens example. What do we charge for this product, for which we have invested over $3.5 million? The answer: Price is determined by the market in which we operate. We will charge what we believe people are willing to pay for these lenses, no matter what they've cost us. The price of competitive or similar products can help us set our price. If we can't keep our costs within our price and make a profit, we will have to go out of business or find something else to sell. Raising our price because our costs increased only works if our competitors do the same.

Knowing these two things, that cost is complex and price is determined by the market, will give you an advantage over many men and women with whom you compete for jobs. Never use the words price and cost interchangeably in conversation. Others may make that mistake, but you should not.

Returning to our income statement example, gross margin, or gross profit, refers to the company's sales revenue after subtracting the direct cost of making the product. We need to measure this to see how successful our product or service is at any particular time. It is called gross, in the sense of an all-inclusive total, because other expenses have yet to be subtracted from it.

The next several items on the income statement example are operating expenses, which will be subtracted from the gross profit figure.

Research and development is a major operating expense in some industries. Companies in the software industry, for example, will spend a substantial portion of revenue on research and development of new products. While programmers' salaries are listed as costs, you can be sure the programmers themselves are considered line personnel.

Sales and marketing expenses refer to the advertising, sales brochures, salespeople's income, and expenses directly incurred in selling the product. Our income statement example is for an entire company, but companies also consider sales and marketing expenses separately for individual products or product lines.

General and administrative costs are lumped together in our example. This category includes administrative and support services, equipment such as computers and copiers, supplies, and expenses such as rent and electricity. These items might be separated in some income statements, and they might be separated for different product lines. The salaries here are paid to staff people. Some or all of these costs are considered fixed costs, because the costs are incurred, even if nothing at all is sold. The costs don't change with various sales volumes. Sometimes these costs are allocated evenly or equitably between departments. Sometimes one division will reflect more of these costs on its records than another, to make the second division look more profitable. How costs are allocated is often a source of disagreement among managers, who are accountable for their own bottom line. Another word for these types of expenses is overhead. The term overhead generally has a negative connotation, since it decreases the company's bottom line, rather than adding to it. Your current position may be considered overhead. Every corporation has some overhead, and management constantly seeks ways to reduce it.

All these operating expenses are added together and shown as total operating expenses.

That figure is then subtracted from the gross profit to come up with total operating income (or loss.) If the figure is below zero, it is put in parentheses, or the letter d (for deficit) appears just before the figure. This operating income is separated from other income, because it reflects the sales of the company and how well those sales supported the expenses of the company. For example, if your company sold a subsidiary (a company it owns,) there might be plenty of money to support expenses and show a profit, but it would be a one-time source of income. The selling of products and services must continue in order for a company to survive, and sales-related revenue and expenses must be measured separately.

Interest income, or interest earned on cash, could be huge, if the company holds a lot of cash, or a much smaller figure. Unless you are in charge of investing the cash, you probably won't need to know or be concerned about it. As with other figures not directly related to sales, interest income is broken out separately from revenue so it doesn't distort sales figures.

Interest paid on loans, along with other miscellaneous expenses, is listed as interest and other expense, net. This is subtracted from the two previous income line items to give us income (or loss) before income taxes. In this case, the terms profit and income are used interchangeably. It is important for individuals to know what they make before taxes, and it is equally important for a corporation to know what it makes.

The next line item shows the company's provision for income taxes., or what the corporation is obligated to pay the IRS for the accounting period.

That figure is subtracted from income (or loss) before income taxes to determine the bottom line: the company's net income or (loss.) This is the profit for the corporation for the specified time period.

It is from this report, the income statement, that the phrase bottom line originates. Expenses are deducted from income sources, and the result is at the bottom of the page. You will hear the phrase bottom line a lot, and it has come to mean the end result of just about anything. When we are bottom-line oriented, we are looking to maximize profit. We want to increase sales and control costs.

Since the company in our example is a publicly held corporation, the profit is divided by the number of shares at the time to come up with a net income per share. Shareholders are more concerned than employees with this figure, unless they are the same people.

The last line item on the income statement, weighted average number of shares outstanding, refers to the number of shares available to trade at any given time. In our example, ABC Corporation apparently added 4 million shares during 1996. This dilutes the value of everyone's holdings, but allows the corporation to offer stock options to employees or raise additional cash by selling shares to the public. The decision to change the number of shares outstanding must be voted on and approved by shareholders.

A few other terms should be discussed here. Profit margin refers to the profit as a percentage of revenue. If you sell a contract for $500,000 that produces $50,000 in profit after all expenses are deducted, your profit margin is 10% (profit divided by sales.) Not surprisingly, some companies pay attention to gross profit margin, net profit margin before taxes, and net profit margin after taxes. Some divisions have specific profit margins to meet each year. When you hear someone speak of margin or margins, think of profit margin. Whether it is gross, net before taxes, after-tax, or some other configuration, you will need to find out.

I have seen highly intelligent people sacrifice enormous profits to maintain profit margin. I once knew a service manager whose performance was measured on profit margin. He would refuse to do a job with a $100,000 profit if the margin was only 10%, but would welcome a $10,000 job with a profit margin of 25%. This is an example of how short-sighted we can be when it comes to the measurement of our jobs. This manager's department made less money than it could have, but he wanted it that way. He was measured not on the dollar amount of profits to the company, but on profit margin. If you find ourself in a similar position, you should approach executives about changing the standard of measurement.

Notice in our example that the year ends September 30. The fiscal year is a full business year. Some corporations choose to begin their fiscal year on a day other than January 1. The year always begins on the first day of a month. A fiscal year may run from July 1 to June 30, or from October 1 to September 30, or whatever period chosen. When referring to the fiscal year, use the calendar year in which it ends. For example, the fiscal year that runs from July 1, 1997, to June 30, 1998, is called fiscal 1998.

The fiscal year is divided into four fiscal quarters of three months each, beginning the first day of the fiscal year. For example, if the fiscal year is July 1 to June 30, the first quarter would run from July 1 to September 30, the second from October 1 to December 31, and so on. Occasionally, a corporation will use a fiscal year other than the calendar year for financial reporting, but use the calendar year for certain budgets. If you are involved in budgeting or forecasting, it is imperative to know the time frame. If your request for new equipment is denied because of budget restraints, you need to know when the new budget kicks in.

Almost every business is seasonal to some extent; rarely do companies receive revenues and profits in a nice smooth influx over time. For this reason, management will compare results from the current fiscal quarter to those from the same fiscal quarter one year ago. For example, a financial report for the second quarter of this year would compare sales and profit figures to those of the second quarter of last year, and perhaps the year before. If you compare results of this quarter to those of last quarter only, you might make false assumptions about the company's success.