The first portion of a corporate income statement, called gross profit, seeks to calculate the profitability of a company’s operations after direct costs. Its ultimate goal is to determine the company’s gross margin.
For example, if you’re a self-employed window washer, your margin would be all the money you make for washing windows, minus the cost of the materials you used to wash those windows (for example, soap, water, and other supplies), but not the cost of your ladder because you use it over and over again.
Net sales on the income statement
Net sales is all the money that a company makes from its primary operations. If the company is a retailer, then net sales includes all the money the company generates from selling retail goods.
If the company is a lawn service but it also offers tree trimming, then net sales includes the money it makes from both services. However, it doesn’t include any money made from other activities outside of its core operation(s). So no counting the extra money made from selling an old lawnmower.
To get net sales, don’t subtract any costs yet. Net sales includes every last dime a company makes from sales; the costs come into play later.
Some companies refer to net sales as gross income, income from sales, or some other similar term. Just remember that net sales is always the very first item on the income statement, regardless of what a company calls it.
Cost of goods sold section of the income statement
To make a product or provide a service, a company has to purchase supplies. Maybe a tool manufacturer needs to buy steel. Maybe a window washing company needs to buy soap and water. Maybe a tutoring company just needs to pay its tutors.
No matter what its primary operation is, every company adds up all the direct costs it incurs as a result of actually making its product or service, not including indirect costs (sales costs, administrative costs, research costs, and so on), and includes them under cost of goods sold (COGS) on the income statement.
The very nature of this section lies within its name: It’s the cost a company has incurred in actually making or buying the goods that it has sold.
Just like the price of beer changes at the store from time to time, the costs of those things a company purchases can change. So when the things a company purchase changes, it must choose how it will measure the cost of goods sold. The two primary ways a company can account for the costs of goods sold are
FIFO (first-in, first-out): With this method, a company will use the costs of those things it purchased earliest when accounting for COGS. In other words, the first inventory made or bought is the first inventory to be sold.
LIFO (last-in, first-out): With this method, a company will use the cost of those things it purchased most recently when accounting for COGS. In other words, the most recent inventory made or bought is the first inventory to be sold.
Because the value of inventory minus costs influences all other financial statements, a company must choose to use either FIFO accounting or LIFO accounting and stick with it for everything.
If a company chooses to switch everything from one method to another, it must describe the change, including the calculated change in value resulting from the change in method, in the supplementary notes of at least the income statement and typically all the other financial statements, as well.
Gross margin section of the income statement
The last part of the gross profit portion of the income statement is the gross margin, which you get by subtracting the cost of goods sold from the net sales.
The gross margin is all the money a company has left over from its primary operations to pay for overhead and indirect costs, like the sales staff, building rent, janitorial services, and everything else that’s not directly related to the production or purchase of inventory.
When you divide gross margin by net sales, you get the percentage of net sales that isn’t spent on producing the inventory. This percentage is extremely important in evaluating a company’s ability to fund supporting operations, plan growth, and create budgets.