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Principles of Accounting IIChapter 23: Profitability

What Is “Profit”?

• Operating profit

• Profit from selling non-inventory item

o E.g.,

• Profit from non-core activities

o E.g.,

o E.g.,

• Extraordinary gain from unusual, infrequent activities

o E.g.,

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All Profit Is Not Created Equal

• Operating profit

o Presumed to _________

o Reflects ___________ or ________________ advantage in ____________

activities

o Suggests ability to generate similar _____________ in future

• Non-operating profit

o Results from ___________, _______-_________ events

o Doesn’t reflect on-going ability to generate __________ profits from

_________ activities

• Extraordinary profit

o Results from _____________ and _______________ events

o Isn’t expected to ___________

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Net Income Has Limits

• Losses from one source (e.g., ________________ events) may offset profits from

another (e.g., _________________).

• Suppose two companies have net income of $____ million. Which would you

prefer?

o $____ million operating profit and $____ million nonoperating loss

o $____ million operating profit and $____ million nonoperating gain

• So, ______ ____________ (i.e., “__________-________” profit) is a limited

measure of profitability.

• It __________ useful information about the profit’s ______________.

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Profit Measures

• _________ ____________ (or _________ ____________)

o Sales less _________ of __________ ___________

o Critical measure for _________________ companies

o ______________ companies do not show this measure.

• ______________ profit (or _________________ income)

o ____________ profit less _____________ and __________________

expenses

o Profits from ______________ __________ activities

• Income before __________ and ___________________ items

o _____________ profit plus

o Nonoperating income (e.g., ______________ income) plus

o Nonoperating gains (e.g., gain from sale of __________________) less

o Nonoperating expenses (e.g., _____________ expense) less

o Nonoperating losses (e.g., loss from sale of ____________ ____________

equipment)

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Real Life, Inc.Gross sales $700,000

Sales returns 61,000

Sales allowances 24,000

Sales discounts 9,000

Net sales $606,000

Beginning inventory $ 35,000

Purchases 525,000

Purchase returns 10,500

Purchase allowances 10,500

Purchase discounts 10,500

Freight and insurance 7,875

Goods available for sale $536,375

Ending inventory 32,000

Cost of goods sold 504,375

Gross profit $101,625

Operating expenses 112,000

Operating loss $ -10,375

Non-operating items:

Gain from sale of idle real estate 128,500

Loss on termite damage in warehouse -43,500

Interest expense -2,540

Income before taxes $72,085

Income tax 25,230

Net income $46,855

Total stockholders’ equity (from balance sheet) $585,691

Evaluate the profitability of Real Life, Inc. Is the company a good investment? Why or

why not?

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Earnings Per Share

• “Earnings per share” expresses _____ income as the amount available for each

_____________ share.

EPS =

• EPS is not the ____________ per share.

EPS Example

Balances, 12/31/01

Preferred stock, 5%, $50 par

[1,000,000 authorized, 20,000 issued]

Paid-in capital in excess of par, preferred

No par common stock

[3,000,000 authorized, 50,000 issued]

Retained earnings

Treasury stock

[10,0000 shares no par common]

Net income

Total dividends declared

EPS =

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Bottom of the Income Statement

• Discontinued operations

o Closed ____________ or discontinued _____________ lines

• Changes in accounting principles

o _____________ changes from one ______________ method to another

acceptable method (not ____________)

o Must be justified in _________ to income statement

• Extraordinary gains and losses

o ____________ and ________________ events

Unusual and Infrequent Events

• _________________ means very unlikely given the _______ business and

________________.

• _________________ means less frequently than every ______ years.

• Whether an __________ is unusual and infrequent depends on the

________________.

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Unusual and Infrequent Examples

• A warehouse is flooded every _____ years or so. If the warehouse is located in a

__________ ____________, it’s _____ unusual and, thus, ______ extraordinary.

• An airline has a plane crash. It’s ______________ but ______ _______________;

crashes are a natural hazard of flying. Thus, the gain or loss is ______

____________________.

• If an airplane crashes into a Kroger grocery store, Kroger reports an

“______________________” gain or loss on its income statement.

Extraordinary or Not?

• Alaska Pipeline breaks a major gas line, and production is down 30% for three

weeks.

• Fairway Dry Cleaners survives an earthquake with damages limited to a broken

gas line.

• Lloyds of London Insurance receives a claim for business interruption (lost

profits) due to rioting.

• Classic Engineering incurs security costs due to rioting in front of their Memphis

facility.

• Early Engineer, Inc. incurs security costs from riots at their D.C. offices (near the

White House).

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Issues in Reporting Income

• Accounting ______________ vary among businesses.

• ____________________ might be based on SL or DDB.

• _______________ allocations may differ.

• Companies generally record assets at ________________ cost and realize gain

only when they sell assets. However, some assets are “______________ up or

down” to ________ _____________ value. The resulting unrealized gain or loss

is reported as “other comprehensive income.”

• Inventory __________ of manufacturing companies includes overhead that non-

manufacturers ______________.

Exercise Professional Skepticism

• Income statements with differing accounting methods are not

“_______________,” but they might not be “_______________” to other

companies.

• To evaluate profitability, one must understand differences in _____________

_________________ so a simple change doesn’t fool you into thinking a manager

just doubled earnings!

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Refresher on Manufacturing Cost

• Inventory cost includes:

o ___________ (raw) material

o ___________ labor

o Overhead

§ ___________ labor (e.g., supervision, security)

§ Minor ___________ (e.g., clean-up solutions, lubricants, rags,

bolts)

§ ___________ costs (e.g., facility, utilities, business license)

• Traditional _____________ ____________, which is required for ___________

financial reporting, includes a portion of _________ production costs in each unit.

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Manufacturing Cost Example

Production Information for Sports RadiosJuly 2002 Cost per Unit

Direct material

Direct labor

Variable overhead

Fixed overhead

Radios produced

Radios sold

Sales

Cost of goods sold

Gross profit

August direct material

(1) What is the per unit cost of producing radios in July?

(2) What is the per unit cost of materials in July?

(3) If production grows to 13,000 radios in August, what will total direct

material costs be in August?

(4) If the radios sell for $20 each, what is the gross profit or contribution

margin?

Now assume August and September production will be 13,000 and 8,000, respectively. If

vendor prices do not change, what is the cost per radio in these months?

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Per Unit Cost

Cost

Per Unit July August September

Revised

September

Direct material

Direct labor

Variable overhead

Fixed overhead

Total manufacturing cost

Radios produced

Radios sold @ $20 each

Cost per unit

Sales

Cost of goods sold

Gross profit

• _______________ cost per unit is the same each month. However, __________

cost per unit changes as production varies.

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Show Me the Profits

We can easily calculate gross profit each month:

Sales = ________ ________ x ________ _________

CGS = ________ ________ x ________ per _________

Gross profit = _________ - _______ of ________ __________

Instead of 8,000 radios, suppose we produce __________ radios in September. Sales do

not change. What do you predict happens to gross profit from producing __________

more radios?

Hitchcockian Profits

• Why did profits increase?

• So, a large chunk of the fixed capacity charge is on the balance sheet as what?

Can Increasing Inventory Raise Profits?

• Mathematically, that is what happens using full _________________ costing.

• But businesses don’t want managers to increase ______________ just to show

higher (illusory) ______________.

• As a result, _______ - ____________ and _________________ costing have

become more acceptable. They mitigate the effect of ______________ profits.

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Unit-Variable Costing

• COGS includes only costs ____________ with production (including

______________ selling).

• All ____________ overhead costs are ________________ in full.

• _______________ charges are viewed as “________” costs. They are

_______________ even if management does not optimally use facilities.

Throughput Costing

• COGS includes only _________ ______________ costs.

• ___________ ______________ and _____ _____________ costs are expensed in

full.

Absorption Costing Results

Cost

Per Unit September

Revised

September

Sales

Cost of goods sold (all costs)

Gross profit

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Costing Comparisons

Unit-Variable Costing

Cost

Per Unit September

Revised

September

Sales

Cost of goods sold (variable only)

Gross profit

Less: fixed overhead

Less: fixed selling expenses

Throughput costing

Cost

Per Unit September

Revised

September

Sales

Cost of goods sold (direct material)

Throughput margin

Less: direct labor and overhead

Less: selling expenses

• _______________ levels don’t change profit _____________ in unit-variable and

throughput costing. Why not?

• With throughput, all ______________ costs (except materials) are ____________

regardless of what is sold.

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Historical Perspective on Inventory Levels

• In the 1970s, ________ inventories were nearly _______ to warehouse because

___________ kept increasing their ________ while they were “on the shelf.”

• More recently, with inflation in check, holding inventories just increases

_______________ costs, ____________ charges, and ___________ risks.

• The ____________ inventory level is just enough to avoid _________-______ but

no more.

• Most businesses ________________ inventory with sophisticated

_____________ that monitors levels closely.

Aggregate Inventory Costs

Beginning Inventory Cost of Goods Sold

Available for Sale

Manufactured Ending Inventory

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Absorption Costing Inventory

June 30 inventory is 1,000 radios, costing $14 each. Calculate ending inventory each

month using absorption costing. Assume the company sells the most recently produced

items first (LIFO).

Units Per Unit Cost Inventory Cost

June 30 1,000 $14.00 $14,000

July 31

July 31

August 31

September 30

September 30

Lower Inventory Cost

• ____________________ capacity (fixed) charges, as with unit-variable costing,

and labor and overhead, as with throughput costing, means those

__________________ costs are not included in _________________.

• Both unit-variable and throughput costing would have resulted in a

____________ inventory cost in our example.

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Product vs. Period Costs

Full Absorption Unit Variable Throughput

Product Period Product Period Product Period

Direct materials

Direct labor

Variable overhead

Fixed overhead

Just for Fun

March

Rental revenue $ 8,000

Accounts receivable 101,000

Salaries, rent, and other admin expenses 300,000

Radio sales revenue 3,000,000

Depreciation expense (20% selling, 80% admin) 130,000

Dividends declared 48,000

Cost of radios sold 2,100,000

Sales returns and allowances for radios 35,000

Loss due to plane crashing into warehouse 122,000

Loss on sale of glue guns 70,000

Interest expense 30,000

Taxes payable 12,000

Retained earnings, beginning 100,000

Tax expense (except for extraordinary items) 15,000

Average number of common shares 120,000

Preferred dividend, $1.20 per share, 10,000 shares 12,000