engg 401 x2 fundamentals of engineering management spring 2008 chapter 3: the income statement dave...

ENGG 401 X2ENGG 401 X2Fundamentals of Engineering ManagementFundamentals of Engineering Management

Spring 2008Spring 2008

Chapter 3:Chapter 3:

The IncomeThe Income Statement Statement

Dave LudwickDave Ludwick

Dept. of Mechanical EngineeringDept. of Mechanical Engineering

University of AlbertaUniversity of Albertahttp://members.shaw.ca/dave_ludwick/

Dave Ludwick, Dept. of Mech. Eng.The Income Statement

Summer 20082

ENGG 401 X2 – Fundamentals of Engineering Management

Income StatementsIncome Statements

• An income statementincome statement summarizes a business’s revenues and expenses– Encompasses a period of time, typically monthly, quarterly, or yearly– The difference between revenues and expenses is the business’s

profitprofit (or lossloss) during that time period.

• It answers the question “how much did we makehow much did we make?” – It is the test of value creation in a business.


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Sample Income StatementSample Income Statement

Source:

Newnan, Whittaker, Eschenbach, Lavelle, Engineering Economic Analysis, Canadian Ed., Oxford University Press, Don Mills, ON, 2006.


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Sample Income Statement (2)Sample Income Statement (2)

Source:

http://www.investopedia.com/articles/04/022504.asp.


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Sample Income Statement (3)Sample Income Statement (3)

Source: http://www.legaldeeds.com/


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Typical Income Statement FormattingTypical Income Statement Formatting

Gross RevenueGross Revenue

– Allowance for Bad Debt/Warranty (optional)

= Net RevenueNet Revenue

– Cost of Goods Sold

= Contribution MarginContribution Margin (or Gross Margin)

– Sales General and Administrative Expense

= Operating IncomeOperating Income

+ Other Income (say, interest on financing)

= Net IncomeNet Income (Profit or Loss)


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TimingTiming

• In Financial Accounting, timing is everything• Consider a company with the following transactions:

– January – PO for steel ($1 million)– February & March – labour to build ($0.6 million), pay for steel– April – product delivered.– May – customer pays $2.2 million

• What is Revenue & COGS in each of the months?– January, February, March, and May – zero– April – Revenue is $2.2 M, COGS is $1.6 M

• Why?


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Amortization and DepreciationAmortization and Depreciation

• Capital assets are long-term assets such as property, plant and equipment which are used to sell products/services over a long period of time (crossing over more than one accounting period)

• Intangible assets are (generally long term assets) which provide some intangible benefit over a period of time (patents, trademarks, goodwill)

• Amortization or depreciation is the process of “writing down” or expensing these assets over the course of their useful lives

• The word “Depreciation” is used to refer to the write down of tangible assets and the word “Amortization” is used to refer to the write down of intangible assets


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Calculating AmortizationCalculating Amortization

• Most common way is to use Straight Line depreciation• Example:

– The business buys a delivery truck for $20000 on Jan 1– The business expects to use the truck for 10 years, at which time it

expects it could dispose of the vehicle for $2000– Annual amortization: (20000-2000)/10 = $1800 / year

Truck Book Value

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

20000

1 2 3 4 5 6 7 8 9 10

Year


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Amortization termsAmortization terms

• Cost of Asset/Purchase price: The original cash outlay required to acquire the asset

• Salvage Value/Disposal Value: The amount that the asset can be disposed of for

• Useful life: The number of accounting periods during which the asset contributes to earning revenue

• Book Value: The cost of the asset less the accumulated depreciation during any period

• Market Value: The amount the asset can actually be sold for at any given time. It is not recorded on the books unless the asset is actually sold


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Variable vs. Fixed CostsVariable vs. Fixed Costs

• Cost of Goods (or Services) Sold (COGS)– also called Variable or Direct Costs– is approximately constant per unit of sales

• Sales, General and Administrative (SG&A)– also called Indirects, Fixed Costs or Overheads– is approximately constant independent of sales

• Are They Fixed or Variable? Depends….– Yes if small change in sales or for the one extra sale

• No incremental discount

• No incremental admin cost

– No for a large change in sales• We need extra admin and marketing

• We can get more favorable terms


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Cost of Goods SoldCost of Goods Sold

• Cost of goods soldCost of goods sold (COGS) is the cost of making or purchasing items and/or materials needed for your final products– Usually when we buy raw materials, we might apply resources

(labour, further raw materials, various services, etc) to bring the inventory to sellable condition

– When preparing inventory for sale, we add all these costs to inventory

– So inventory captures (or capitalizes) the cost of making, delivering (service) or buying (wholesale or retail) a product

– what is included in COGS varies widely from company to company, but should not vary from year to year


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Cost of Goods Sold ExampleCost of Goods Sold Example

• Which of the following items would you classify in COGS?1. Circuit boards that go into the manufactured item

2. Stationery for use in the office

3. The pay of the receptionist in the sales office

4. The pay of the receptionist in the manufacturing plant

5. Miscellaneous screws and fittings

6. Telephone charges

7. Raw steel for structural members

8. The pay of a welder brought in on contract

9. The pay of a welder on salary

10.The pay of the floor sweeper in the manufacturing plant


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Cost of Goods Sold Example (2)Cost of Goods Sold Example (2)

• Which of the following items would you classify in COGS?11.The cost of contract cleaning in the manufacturing plant

12.The cost of the crew of a service vehicle

13.The maintenance charges of a service vehicle

14.The annual registration cost of a service vehicle

15.The cost of annual business permits

16.Welding consumables (i.e. welding rod)

17.The pay of the shipping department

18.Part or all of the company president’s salary

19.Freight on inbound materials

20.Freight on outbound products (assuming FOB point is remote from the factory, i.e. the manufacturer pays the freight rather than the customer.)


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COGS and Contribution MarginCOGS and Contribution Margin

• Contribution marginContribution margin (or just simply marginmargin) is the difference between net revenue and COGS– expressed as a percentage of gross revenue– is a crucial measure of some businesses (year over year),

especially distribution-type businesses

• Margin is an extremely sensitive business fact– no company likes to reveal its true marginal (variable) costs– it tells a competitor the pricing level that will cause the company to

lose on every sale


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COGS and Contribution Margin (2)COGS and Contribution Margin (2)

• In a perfect world, margin is fully variable at a known and fixed rate (i.e., proportional)– … but in practice, this is only true for small deviations in sales– however, it still gives good guidance in business decisions

• A vessel fabrication shop uses a great deal of welding rod. Should this be considered part of COGS?– Yes: it is a variable cost, and the true measure of margin would treat

it as variable.– No: the effort to do a bookkeeping entry for each use of welding rod

is not justified by the value of the extra precision in information– It becomes a business/judgment call as to how much effort you want

to make to track these expenses

• On balance, we often lump untracked costs (or small but variable costs) into SG&A.


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Sales, General, and AdministrationSales, General, and Administration

• SG&ASG&A captures the cost of running a division or a company.

• By definition SG&A cannot be calculated by product or product line, because it includes a more general level of costing (e.g., the president and receptionist).

• Unambiguous examples include senior staff, corporate finance departments, corporate memberships, basic phone system charges.

• It usually includes sales cost, but if sales cost are strictly per product they can be put into COGS.


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Sales, General, and Administration (2)Sales, General, and Administration (2)

• In theory, SG&A is “fixed”; for small changes in sales this is an accurate assumption.

• SG&A should grow at less than the rate of growth of sales, or the company has a serious problem!

• In many businesses, a long period of “good times” leads to growth in SG&A (e.g. more support staff). This is “wrung” out of the business in down cycles.

• Allocation does not create marginality!


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More on MarginMore on Margin

• Margin is the cash left over from a sale that can contribute to covering the fixed costs.

• The objective: build sales to have enough margin to:– First, reach cash break even– Second, reach book breakeven– Third, reach high profitability and return on investment

• In theory– Margin is varies proportionally (exactly) with increasing sales– SG&A is truly fixed


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More on Margin (2)More on Margin (2)

• In theory

$

Sales Volume

MarginSG&A excl. depreciation

SG&A incl. depreciation

Profitability

Book breakeven

Cash breakeven


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• In the best real case:– Margin increases as you hold price and get volume discounts on

your inputs– SG&A growth is minor as sales increase– Peace breaks out around the world


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• The best real case

$

Sales Volume



Profitability

Book breakeven

Cash breakeven


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• In the investor’s nightmare:– SG&A excluding depreciation goes up as you discover that you

need more and more marketing staff to chase sales– Depreciation goes up as you need more fixed assets– Margin falls as you “buy” sales by discounting price


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• The investor’s nightmare

$

Sales Volume



Profitability not reached

Book breakeven not reached

Cash breakeven


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Discussion Question #1Discussion Question #1

• Think about how many hours per year each of the following pieces of equipment operates. – pump in an oil refinery– telephone switch– family automobile– lawnmower

• How many hours in the total life of the piece of equipment?


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Discussion Question #2Discussion Question #2

• Two brothers inherit $1 million each. The conservative brother buys a 20 year bond yielding 5.5% and hence makes $55,000 per year. The entrepreneurial brother buys two oil well service rigs, and makes $70,000 a year in cash from the business. 15 years later, over a beer, the entrepreneurial brother brags that he made the better choice. Assuming the entrepreneurial brother didn’t work in the service rig business (i.e., he had another job), was he right? Why?

engg 401 x2 fundamentals of engineering management spring 2008 chapter 3: the income statement dave...

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