income statement

Manufacturing companies are companies that make a product. Because these companies have inventory in various stages of production, there are three inventory accounts that we must deal with in order to calculate cost of goods sold. The three inventory accounts are:

  1. Raw materials inventory
  2. Work-in-progress inventory
  3. Finished goods inventory

Each of these accounts must be calculated to see how much inventory from that account moves to the next account and eventually to cost of goods sold. The basic calculation for each of the accounts is the same.

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

The important thing here is knowing what gets added to the account and knowing the proper label for the amount that is transferred out of the account. This is where terminology is key to your understanding and performing the calculations correctly. When I’m thinking about inventory accounts, I like to imagine three rooms within the product facility, one for each of the types of inventory. Try to think about what is in each room, the costs that are added to the goods in that room and what happens to items that leave the room.

three rooms for inventory

Raw Materials Inventory

Raw materials inventory is the inventory of materials waiting to go into production. These are components of our product that have been purchased to make our product. In this case, we start with beginning inventory for the raw materials inventory account. What do you think we add to this account? We would add purchases of raw materials. Next, we subtract the ending inventory in the raw materials inventory account which is obtained by counting what is still on hand at the end of the period.

What happened to the stuff that is no longer there? Those materials were requisitioned by employees to use in the production process. They are being used to make our product. We call the materials that were taken from the room materials used in production.

Those materials were transferred into work-in-progress inventory.

RM room

Raw materials inventory is pretty straight forward.

RM formula

Work-In-Progress Inventory

Now that we have put materials into production, what else goes into the cost of our product? The three product costs are direct materials (which we have already placed in the room), direct labor, and manufacturing overhead. These three accounts are also called manufacturing costs. Add the cost of materials used in production to direct labor and manufacturing overhead costs. These costs are our “something added to the account.”

WIP Room before inventory

We have not yet figured in beginning and ending inventory for the work-in-process account. Just like the previous room, take beginning inventory and add your total manufacturing costs (our “something”) then subtract ending inventory. If goods transfer out of this room, it is because they are finished. Those goods are called cost of goods manufactured because they have finished the manufacturing process. They are now complete and have been moved to the finished goods room.

FGI Room before inventory

When calculating work-in-progress, add your materials used in production, direct labor cost, and manufacturing overhead cost to get total manufacturing costs. Then the formula is similar to our raw materials calculation.

WIP formula

Finished Goods Inventory and Cost of Goods Sold (FINALLY!!)

We have finally made it to the last room. We have transferred cost of goods manufactured into finished goods inventory. For this room, this is our “something”. Add beginning inventory and subtract ending inventory balances for finished goods inventory and we are done.

FGI room

The items that leave the finished goods inventory room leave because they have been sold and therefore, are called cost of goods sold. The formula for this calculation is very similar to both of our previous calculations.

FGI Formula

Once you have completed these calculations, the income statement for a manufacturing company is exactly the same at the income statement for a merchandising company. Both statements use cost of goods sold to calculate gross profit, then subtract selling and administrative expenses (or operating expenses) to arrive at operating income.

Manuf IS

Final Thoughts

While the calculations for cost of goods sold for a manufacturing company may seem overwhelming, remember that the calculations for each inventory account are very similar:

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

When you try to create a story to explain the process, you will not need to remember the formulas. Think about how the materials are moving through the company and into production, where labor and overhead are added. When goods are finished, they transfer to the finished goods inventory account. Once they are sold, they are transferred out of the finished goods account to the income statement as cost of goods sold.

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Merchandising companies sell products but do not make them. Therefore, these companies will have cost of goods sold but the calculation is much easier than for a manufacturing company. Expenses for a merchandising company must be broken down into product costs (cost of goods sold) and period costs (selling and administrative).

Just like all income statements, the first line is revenue. In the case of a business that sells a product, we refer to revenue as Sales or Sales Revenue. This lets the reader know that the company generates its revenue from the sale of products rather than the delivery of services.

Cost of Goods Sold

Next, we subtract cost of goods sold. Cost of goods sold is the cost of all the products (goods) that were sold during the period. If the company uses a perpetual inventory system, cost of goods sold is being calculated every time a sale takes place.  In this case, no calculation is needed. We can simply take the amount from the cost of goods sold account on the trial balance. And you thought you could forget everything from financial accounting!

If the company uses a periodic inventory system, we must do some calculations to figure out cost o f goods sold. Under a periodic inventory system, all goods purchased as placed in the Purchases account, not the inventory account. When sales are recorded, there is no adjustment to inventory and cost of goods sold like there is in a perpetual system. Therefore, at the end of the year, we must look at how much was purchased and physically count how much inventory is left in order to manually calculate cost of goods sold.

InvCost1

Under a periodic system, we add beginning inventory to the cost of purchases. This gives us goods available for sale. Goods available for sale is the maximum value of goods that could be sold. If we sold every unit we had on hand and had no inventory left at the end of the year, goods available for sale would equal cost of goods sold. If there is inventory remaining, we must subtract the ending inventory from goods available for sale to calculate cost of goods sold.

To calculate cost of goods sold under a period inventory system:

Beginning Inventory
Plus: Purchases
= Goods Available for Sale
Less: Ending Inventory
= Cost of Goods Sold

Let’s look at an example to help illustrate the point.

Example #1

Kingram Pencil Pushers sells pencils to office supply stores and other retailers around the world. On January 1, the company’s inventory was $41,000. During the year, the company purchased $895,000 worth of pencils. A physical count of the inventory on December 31 revealed that there were $23,000 worth of pencils remaining. Calculate cost of goods sold for the year.

Whenever you are working on a word problem, the first thing you want to do is remove the numbers from the problem and label them. We are told that January 1 inventory is $41,000. How would you label this number? If you said beginning inventory you are correct. January 1 is the beginning of the year, hence our beginning inventory.

$41,000 beginning inventory

How would you label $895,000? Well we are told this is what the company purchased, therefore this is the amount of our purchases.

$41,000 beginning inventory
$895,000 purchases

Can you guess what the last number is? Ending inventory! If January 1 is the beginning of the year then December 31 is the end of the year.

$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory

What is the problem asking us to do with these numbers? Calculate cost of goods sold.

$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory
?????? cost of goods sold

Okay, let’s think about this logically. We need to figure out what we sold. Now we can jump to the formula or we can try to think this through without the formula. What is cost of goods sold? It’s the stuff we sold, therefore it is no longer in the building. So if we take the stuff we could have sold (goods available for sale) and subtract the stuff we have left, we can figure out what was sold.

What is the maximum amount of goods that were available for sale? Well we had some pencils, $41,000 worth of pencils actually. Then we purchased more pencils, $895,000 worth. So if we add the pencils we had, plus the pencils we bought, that tells us how many pencils we had available that could have been sold.

Goods available for sale

So we could have sold $936,000 worth of pencils but we know we had some pencils left so our cost of goods sold must be less than $936,000. Cost of goods sold CANNOT be more than goods available for sale. I can’t stress this point enough because this is where a lot of people mess up this calculation. If you keep in mind that cost of goods sold cannot be more than goods available for sale, it might save you points on your next exam.

I have $23,000 worth of pencils leftover. These pencils were not sold. So if I take the number of pencils I could have sold and subtract what I did not sell, that will tell me what I did sell.

Cost of Goods Sold

Of the $936,000 in pencils we could have sold, $913,000 were sold. That is the answer to the problem.

Putting together the income statement

It’s been a long, strange journey to get here but we are finally ready to do our income statement. Once you have cost of goods sold, the rest of the statement is fairly easy. Here is the format:

Sales
Less: Cost of Goods Sold
=Gross Profit
Less: Selling and Administrative Expenses
=Operating Income

This is called the traditional format income statement. Later on in the course, we will discuss another format for the income statement called the contribution margin income statement. This statement breaks out costs into product and period costs. Gross profit is the amount from sales that is left over after your product is paid for. This is an important figure for many companies because it lets the company know the average percentage of each sale left over to cover operating expenses and generate profit.

Let’s look at an example of a traditional format income statement for a manufacturing company:

Merch income statement

You will notice that there is less detail in this statement than there was in the service company income statement. You can add all the detail if you wish but many times that causes the statement to become a bit cluttered, especially if you are putting in a subtotal for selling expenses and another for administrative expenses. Many times selling and administrative expenses are called operating expenses. These terms are used interchangeably. Sometimes, you will just see operating expenses or selling and administrative expenses and the total without the breakdown shown above. This format is also perfectly acceptable.

Merch IS less detail

Final thoughts

When creating the income statement for a merchandising company, it is important to break costs out into product costs and period costs. If you are working with a company that uses a perpetual inventory system, cost of goods sold will already be computed for you. In a period system, you will have to do some calculations to compute cost of goods sold. Focus on what is actually happening, the business process, and the calculations are much easier. Don’t forget to calculate gross profit (sales – cost of goods sold). Operating expenses and selling and administrative expenses can be used interchangeably to refer to period costs.

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The four basic financial statements are the income statement, the statement of retained earnings, the balance sheet and the statement of cash flows. Due to the complexity of the statement of cash flows, you can find information on that statement in a separate post. Our purpose here is to get a basic feel for what goes on each of the statements and the purpose of each statement.

The first thing you should do when starting any statement is the heading. The heading tells the reader what he or she is looking at. The heading for all statements is as follows:

Company Name
Name of the Statement
Date

The date can be a bit tricky but we will discuss that in the context of each of the statements.

You must prepare the financial statements in a particular order:

  1. Income Statement
  2. Statement of Retained Earnings
  3. Balance Sheet
  4. Cash Flow

The reason for this is because you will need information from the previous statement to complete the next one. You will see the flow of information as we complete an example. It is important to note that you will only use each number from the trial balance one time. Once a number has been used, it will not be used again. Notice that I did not write once you use an account, you will not use it again. There is one account that will be used on two different statements. Can you guess which one?

 The Income Statement

From the name, you should be able to tell that the statement has something to do with income. Income makes me think of revenue, but when working with businesses, most of us think of income in terms of profit. Revenue is nice but at the end of the day, those of us who are small business owners don’t get to take home our revenue because we have to pay expenses. Another name for the income statement is the profit and loss statement. The basic format for the income statement is revenue – expenses = net income.

The income statement is like a movie that tells us everything that happened in the business for the year. It includes all revenue generated and all expenses incurred. We can tell if the business borrowed money at any point in the year by looking for interest expense. We can tell if the company owns or rents the space it occupies by looking for rent expense. Does the company have employees? Look for wage expense. The income statement covers the entire period, whether that is a month, a quarter or a year. Therefore, when completing the income statement, the date in the heading should be For the (month/quarter/year) ended (date). For financial statements generated for a year long period of time that ends on December 31, 2013, the date on the income statement would read For the year ended December 31, 2013.

Where do we get the information for the income statement? From the trial balance! I like to think of the trial balance was the primer for financial statement preparation. Here is the trial balance used in the post discussing them.

FS1

 The trial balance is organized to help us prepare the financial statements. Notice that revenue and expenses are listed together to make preparation of the income statement fairly easy.

FS 2

 Notice in our statement, we listed revenue on top. If there were multiple revenue accounts, we would list them all and then get total revenue like we did for expenses. We then used our formula, revenue – expenses = net income to complete the statement.

Remember that this is a basic income statements. There are more complicated formats for the income statement but this is the basis for all income statements.

 The Statement of Retained Earnings

The statement of retained earnings helps us update the balance in the retained earnings account. You will note that we have not completed a single journal entry to Retained Earnings through this process. We will use retained earnings in entries when we discuss closing entries. Because we have not entered any entries into the Retained Earnings accounts, the current balance in the account is last year’s balance. It has not yet been updated to reflect the change for this year. The statement of retained earnings is the first step in updating that balance.

Retained earnings is the amount of earnings that the company has kept (retained) over the years that the company has been in business. Each year the company generates earnings, also called net income. Some of these earnings may be paid out to the owners in the form of dividends or distributions. The difference between net income and distributions to owners is the amount that is added to the previous retained earnings balance. Therefore, the format for the statement of retained earnings is:

Beginning Balance, Retained Earnings (from the adjusted trial balance)
Plus: Net Income
Less: Dividends or Distributions
Equals: Ending Balance, Retained Earnings

Net income is taken from the income statement and dividends or distributions are taken from the trial balance.

FS1

Notice on our trial balance, the items we need are highlighted in blue. We look to the income statement which tells us our net income is $29,800. We have everything we need to complete the statement.

FS3

Note: For the date on the statement of retained earnings, we use “For the year ended December 31, 2013” because the income statement is involved in the statement. The statement of retained earnings covers all the changes to retained earnings over the course of the year, just like the income statement.

The Balance Sheet

If you look at the trial balance, you will notice that the only accounts we haven’t used are assets, liabilities and equity. Hopefully, this makes you think of the accounting equation, which states that Assets = Liabilities + Equity. We know that this equation always has to balance. The balance sheet is essentially the representation of the accounting equation. We are showing on a statement that assets do indeed equal liabilities and equity.

Unlike the income statement and statement of retained earnings, which tells us the story of the year, the balance sheet is a snapshot of the balances on the last day of the year. It is like a photograph rather than a movie. The balance sheet does not show us all the fluctuations in the balances throughout the year. It does not even show us the high and low balances for the year. It literally only shows us the balance on the last day. Therefore, when writing the date for the heading, we only put the last day. For the example we have been using, we would write “December 31, 2013”. That is all. No “For the year ended” here because it is not for the entire year, it is just for December 31.

At the beginning of the post, I stated that each statement would require something from the previous statement. What do we need from the statement of retained earnings? What type of account is retained earnings? It’s an equity account, which means that it needs to go on the balance sheet. I asked in the first section if you could guess which account is used on multiple statements. The answer is Retained Earnings, which appears on the statement of retained earnings and the balance sheet. Do not take the Retained Earnings balance from the trial balance. Use the ending balance from the statement of retained earnings.

 FS1

Here is our basic balance sheet:

FS4

Notice that the equation does balance. The amount in Retained Earnings is the amount from the statement of retained earnings and not the trial balance. This is a basic, non-classified balance sheet. There are some balance sheets that show current and long-term assets, current and long-term liabilities and a separate equity section. More complex forms of the statements will be discussed in future posts.

Note: If your balance sheet does not balance, here are a few things to check:

  1. Did you only use revenue and expenses on your income statement? Remember that you can draw a line above your first income account and everything below that line should go on the income statement. Only the items below the line should go on the income statement.
  2. Did you subtract Dividends/Distributions on the statement of retained earnings?
  3. Did you use the ending Retained Earnings balance on your balance sheet?

A few other quick tips to keep in mind when preparing your statements.

  1. Prepaid Expenses are an asset, not an expense. It goes on the balance sheet!
  2. Accumulated Depreciation is a contra asset, not a liability. Subtract it from assets!
  3. Unearned Revenue is a liability, not revenue. It goes on the balance sheet!

Use your trial balance as a guide. Know where to separate the accounts and you will be much less likely to make a mistake.

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Creating the Financial Statements

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