Financial Columns
   (Originally Appearing in The Motely Fool)

The Cost of Doing Business
Back to Basics, Part 12

By Vince Hanks

Whether it's selling doughnuts to morning commuters or building space shuttles for NASA, running a business costs money. These expenses are listed on the income statement right below sales and revenues, which we discussed last week. Subtract expenses from sales and revenues and you arrive at taxable income.

The most substantial expense we encounter is usually cost of goods sold (COGS). Cost of goods sold are the expenses of purchasing materials and preparing goods for sale. These costs can include labor, materials, overhead, depreciation, and psychic advisors. OK, maybe not psychic advisors.

Inventories, which were discussed a few weeks back in the current assets segment of the balance sheet, have a strong relationship with COGS. If you add the inventory on hand at the beginning of the year with any inventory purchased during the year, that total will be split between inventory remaining at the end of the year, which is listed on the balance sheet, and COGS.

Sounds fairly straightforward, eh? If it were only so. The problem arises with the way a company can flow costs through the books, which may or may not resemble the way the goods were actually handled. When reporting sales, profit, and remaining inventory on hand, a company may use first-in, first-out (FIFO), last-in, first-out (LIFO), or the weighted average method.

With FIFO, the inventory acquired first is considered to be sold first. This is the way goods are typically sold by a firm (don't want that spoiled milk left on the shelves). LIFO, conversely, lists items purchased most recently as those going out the door first. The incentive for using LIFO is twofold. First, LIFO usually results in higher income tax deductions. Also, if you consider that the cost to replace inventory will likely be equal or greater to that of the most recent purchased, LIFO is a closer representation of the current cost of business operations.

The final method is a compromise between how it probably happened and how it's best portrayed on the books. The weighted average method values both COGS and ending inventory using the weighted average cost of all inventory available for sale. If you purchased five units over time at costs of $2, $4, $6, $8, and $8, respectively, you would list each unit at a cost of $5.60 (2+4+6+8+8 / 5 = 5.6).

Using LIFO may lead to lower earnings than FIFO or the weighted average method, all else being equal. However, a company using LIFO will generally pay lower income taxes and therefore produce greater cash flows. Consequently, companies generally will choose LIFO as the preferred accounting method.

Factory overhead consists of all indirect costs associated with the production of goods. In other words, all production costs other than direct labor and raw materials fall under this heading. Included in factory overhead is the payroll of supervisors, plant maintenance, general supplies, depreciation of plant and equipment, insurance, and electricity, among other things.

Factory overhead and direct payroll are considered fixed costs because the amounts generally remain the same over a production cycle. As production volume increases and fixed costs remain the same, profits should rise.

Gross profit may or may not be listed next on the income statement; often it's omitted. Gross profit is the difference between net sales and COGS.

The final expense we run into is listed simply as operating expenses. Operating expenses may be further broken down into selling and administrative expenses. Selling expenses are those costs associated with producing sales, and administrative expenses are the costs of managing operations. A company usually will not list a specific breakdown of operating expense on the income statement. This category includes items such as salaries, benefits, amortization of goodwill, supplies, and equipment expense. Basically, any expense incurred in transacting normal business operations outside of interest, taxes, and cost of goods sold.

>> Income Statement Odd & Ends >>

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