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The Earnings Statement is a financial report that shows business profitability over some time period.  This lesson will focus on the expense portion of the Earnings Statement.

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Quick reference

Earnings Statement Part 3

The Earnings Statement is a financial report that shows business profitability over some time period.  This module will focus on the expense portion of the Earnings Statement.

When to Use Earnings Statements

The Earnings Statement is prepared for a time period typically a month, quarter, or year.  It shows the sales and expenses during that time and ultimately whether or not the company made money (profit) during that time.

Instructions

  • All financial transactions for a time period are accumulated and shown on the Earnings Statement.
  • The revenue transactions are placed in one category.
  • The expense or cost transactions are normally placed in multiple categories. 
  • After the expenses have been subtracted from the revenue, the remainder is called Earnings, Net Income or Profit.
  • Expense transactions are included if their timing attribute is within the period represented by the Earnings Statement.
    • If cash basis, the timing is based upon making a payment for the goods or services.
    • If accrual basis, the timing is based upon the receipt of goods or services.
  • Special one-time expenses are typically recorded as separate line items so it is easy for analysts to remove them from their ongoing progressions. 
  • Cost of Goods Sold (COGS) is also referred to as variable cost because these costs vary based upon the amount of sales.  The COGS in the Earnings Statement is only the costs of producing the products or services that are sold during the time period associated with the Earnings Statement.
  • The COGS, or variable cost, is comprised of three components:
    • Direct material – material that is incorporated into a product that is sold.
    • Direct labour – labour to manufacture the product sold or labour required to complete a service call with a customer.
    • Variable overhead – overhead costs that are directly related to running a manufacturing operation.
  • Operational expenses are often referred to as fixed costs, overhead costs, or SG&A – sales, general and administrative.
  • Operational expenses can be classified in five categories – these will be discussed in more detail in other modules:
    • Fixed costs – typically do not vary from period to period regardless of business activity.  These are often based upon a contract.
    • Overhead costs – “run the business” costs.  These include staffing and operating expenses of business support functions such as HR, Finance, Marketing, and Engineering.
    • Program costs – these are the costs of doing projects.  Therefore these are the most discretionary of all costs since normally projects can be easily stopped, started, or stretched – which changes the amount of money being spent.
    • Interest costs – payment of interest on whatever loan or borrowing instruments used by the company.  The payment terms and interest rate are normally determined by the lending the institution.
    • Taxes – these expenses are based upon the tax code of the applicable government agencies.  Businesses can curtail or expand certain types of business activity in order to minimize taxes.

 

Hints and Tips

  • All transactions are recorded either using the cash basis or the accrual basis – never mix these on a statement.
  • Many companies will break the operating expenses into further subcategories within each of the categories mentions, such as R&D, depreciation, sales, IT, or other categories that are of significant importance to their industry.
  • Although Interest and Taxes are not normally categorized as operating expenses, their behavior is much closer to operating expenses than to variable costs.
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  • 00:04 Hi, this is Ray Sheen.
  • 00:06 Let's talk about earning statements one more time.
  • 00:08 This time I'll focus on the expense portion of the earning statement.
  • 00:13 Recall that the earning statement shows the total revenue and expenses for
  • 00:17 some time period.
  • 00:19 Subtracting the expenses from the total revenue gives the net income or
  • 00:22 profit during that time.
  • 00:24 The financial definition of expenses is the decrease in owner's equity due to
  • 00:28 operating the business.
  • 00:29 This just means that the expenses are the money that is spent running the business.
  • 00:33 In addition to the normal operating expenses,
  • 00:36 the expenses shown on the earning statement will include any special or
  • 00:40 one-time expenses, but they're often shown as a special sub-account.
  • 00:44 As we said in other modules, the expenses on the earning statement are for
  • 00:47 some time period, either a month, a quarter, or a year.
  • 00:51 If the business uses the cash basis, the expenses listed will be those for
  • 00:55 which the company actually paid cash in that time period.
  • 00:58 If the business uses the accrual basis, the expenses listed will be those for
  • 01:02 which it received the invoice, whether the bill was paid or not.
  • 01:05 If we look at the earnings statement again,
  • 01:07 we see that expenses are in two basic categories.
  • 01:10 COGS, and operating expenses.
  • 01:12 Let's look at COGS first.
  • 01:15 Cost of Goods Sold, or COGS, is considered a variable cost.
  • 01:20 These are the costs of actually making a product, or
  • 01:22 delivering a service to a customer.
  • 01:24 It is the material and labor that goes into providing
  • 01:27 whatever is delivered to a customer, and that is the key.
  • 01:31 All types of cost variant business, but the categories of variable cost means it's
  • 01:35 a cost associated with providing something to a customer.
  • 01:39 They are considered to be variable because they vary with the level of sales.
  • 01:43 If we sell one more unit we must spend the money to make one more unit.
  • 01:47 If we sell one less unit, we can save the money by not making that unit.
  • 01:51 On the earnings statement, we show the variable cost for the units of products or
  • 01:55 services that were sold in that period.
  • 01:58 That is why they are called the Cost of Goods Sold.
  • 02:01 If we sold nothing during the time period of the earning statement
  • 02:03 the COGS would be zero.
  • 02:06 There are three elements of variable costs for COGS.
  • 02:08 First is the direct material that is used in the product.
  • 02:11 Second, the actual direct labor of making the product or delivering the service, and
  • 02:16 finally, the variable overheads.
  • 02:18 This is a small fraction of the management and supervision and support overhead
  • 02:22 factors that are tied directly to the activity of making products.
  • 02:26 So for instance, if we ship one more unit,
  • 02:29 we have to use a little more styrofoam peanuts in the shipping container.
  • 02:33 Or if we need to put a second shift on to meet a spike in demand,
  • 02:36 we need a supervisor for that shift.
  • 02:39 The other category of expenses on the earnings statement is operating expenses.
  • 02:44 Now I'm going to be using a very broad definition of this expense.
  • 02:47 We will break it down in more detail in other modules, but
  • 02:50 this is the cost of running the business.
  • 02:52 I sometimes express it as the cost associated with opening the doors
  • 02:55 everyday.
  • 02:56 These costs won't change based upon sales volume.
  • 02:59 For instance, if we have a security guard at the front door,
  • 03:02 we don't need to add more security guards there just because we sold one more unit.
  • 03:07 These costs go by many different names.
  • 03:10 A common one is SGA, which stands for sales, general, and administrative.
  • 03:14 And in this case, the sale means the sales force, not the cost of making or
  • 03:19 delivering what has been sold.
  • 03:21 When I talk about these costs, I normally differentiate them into five broad
  • 03:25 categories, based upon how the costs behave or
  • 03:27 how they must be reported on financial reports.
  • 03:31 We'll talk about most of these more in other modules, but
  • 03:34 let me briefly explain them here.
  • 03:36 The first category I'm calling fixed costs.
  • 03:39 These are fixed because they don't change from month to month.
  • 03:42 They typically were determined by a contract of some type.
  • 03:45 Things such as rent or insurance costs fit in this category.
  • 03:49 As an operational manager, you can easily impact these once they're set.
  • 03:54 The next category is what I call the overhead cost.
  • 03:57 These are typically the costs of overhead departments or
  • 03:59 functions such as the HR department,
  • 04:01 finance department, even the engineering department doing sustaining engineering.
  • 04:06 These departments keep the business running.
  • 04:08 They normally do not directly make product, rather they create the business
  • 04:12 environment that allows the company to directly make products.
  • 04:15 Too much cost in this area indicates bloated bureaucracy.
  • 04:18 But too little, will leave the organization fragile and
  • 04:21 unable to respond to typical business issues.
  • 04:24 They are what keeps the business running.
  • 04:27 The third category is program costs.
  • 04:29 These are the costs of doing programs and projects.
  • 04:32 These costs are discretionary, but they also are often how we create and
  • 04:36 implement the strategy.
  • 04:38 Whether it is new products, new systems, advertising campaigns, or
  • 04:41 6 CIGMA initiatives.
  • 04:42 These are the costs that are needed to improve the business.
  • 04:45 As I said, these are discretionary and
  • 04:48 are usually the first costs that are cut in a cost savings campaign.
  • 04:51 And they're the first things added when more money becomes available.
  • 04:55 The fourth category is interest or debt.
  • 04:58 This is accounted for separately on the earnings statement.
  • 05:00 It is similar in nature to the fixed cost and the way it behaves, but
  • 05:03 financial rules cause us to report it as a separate line item.
  • 05:07 Finally, there is the category of taxes.
  • 05:10 There are many factors that go into determining this cost and
  • 05:13 they vary based upon the tax code of each of the locations of the business.
  • 05:17 From an operating manager's perspective we normally don't worry about this.
  • 05:20 The finance department has specialists who keep track of the tax codes and
  • 05:24 how it applies.
  • 05:25 From our standpoint, it's just another cost that is added on to the earning
  • 05:29 statement after everything else has been accounted for.
  • 05:32 So those are the expenses on the earning statement.
  • 05:36 As operating managers, we will need to track these very closely.
  • 05:39 In fact, many of the remaining modules in this program will talk about how to do
  • 05:44 the planning and tracking of those expenses.

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