The next stop on our tour of the business cycle is the realm of costs and expenses.
Revenue minus costs equals gross profit. Gross profit minus expenses equals net profit.
The first line at the top of the income statement is revenue, the top line. Immediately beneath the top line is the Cost of Goods Sold, or COGS. For a service company this is the cost of services. COGS are all the costs directly associated with making the product or delivering the service, including materials and labor.
Some of these costs are clearly related to the product:
Some costs are clearly not part of the product:
Then there are gray areas—enormous gray areas:
"Up above the line or below the line," are terms accounting managers use. The "line" generally refers to gross profit. Above that line on the income statement are sales and cost of goods. Below the line are operating expenses, interest, and taxes. Items listed above the line have more variance than many of those below the line. More variance gets more managerial attention.
Where to draw the line between cost of goods and operations expenses is a matter of interpretation for the accounting managers and the financial officer. This is a subjective decision. Examples exist of cases in which a lack of critical thinking about this decision caused a failure to recognize the impact of changes in business conditions. Sometimes the decision made only optimizes the accountant’s efforts.
Let us look at how this decision can affect a retail or wholesale business.
The merchants—the buyers of an organization—are responsible for generating higher gross profit, also known as gross margin. Remember, revenue less costs equals gross profit. The merchants must decide what products to sell and at what price, and negotiate the cost with the supplier.
Logistics, distribution, inventory management, store operations, and other operations and administration departments are responsible for controlling the rest of the expenses. These departments must get the product to the shelf, sell it to the customer, collect the money, pay the bills, and report performance.
For a retailer or wholesaler, the above-the-line costs are clearly the cost of purchasing the goods. Gross margin is often the performance measure used to determine the effectiveness of the merchants.