Calculating Shop Rates Using The Income Statement

We are going to spend the next few posts reviewing what an income sheet is and how the income sheet will help you determine you shop rates.

From Wikipedia the definition of income statement is

Income statement, also called profit and loss statement (P&L) and Statement of Operations, is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the “bottom line”). The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

An income statement is the primary source of information which enables you to calculate your overhead absorption rates.   Overheads are the total cost of all indirect materials, indirect labour and indirect expenses.   All expenses that you cannot attribute directly to the manufacturing of a product or service are included in overheads.

Here are some common items and definitions of those items on the income statement.

These items would not be used in the overhead absorption calculation

• Net Sales: amount of money made from the goods or the services that you sold. This is what you were physically paid. It is the price of the sale minus any discounts that you gave out and minus the value of any goods returned or services that were not needed.
• Cost of Goods Sold or Cost of Sales: amount of money it took you to be able to have the goods or services ready. Includes things such as materials and labor costs incurred to make the product or labor that supplied the service. You may have a cost related to a service as well as a good. Overhead is also included in here.
• Gross Margin: a calculation area on the income statement. The value is Net sales – Cost of sales. This shows how much money you receive compared to what it cost to made the good or service. The gross margin shows you how much money you have available to pay your expenses and still make a profit.
• Selling and Administrative Expenses: costs involved in getting the product or service ready to sell that are not directly related to the product itself. It includes salaries for people not directly involved with the making of the product or performance of the service, advertising, office expenses, etc. Research and development costs are usually included in this section.
• Selling and Administrative Expenses: costs involved in getting the product or service ready to sell that are not directly related to the product itself. It includes salaries for people not directly involved with the making of the product or performance of the service, advertising, office expenses, etc. Research and development costs are usually included in this section.
• Operating Income: income from selling your product or service minus the cost to make the good or service directly, and minus costs associated with running the particular type of business. It can also be thought of as gross margin – expenses incurred to operate your business. This reveals the amount your company has left over after paying it’s own costs to function as a business entity.
• Dividend and Interest Income: additional money that you receive from ownership and investments externally. Dividends are your portion of another company’s earnings. Interest income is money that you make as a result of allowing someone else to borrow money from you. It is safety money in the event that your business is not profitable in one year. It allows a business to rely on sources outside of its self.
• Operating expenses:  additional expenses incurred in carrying out the firm’s day to day activities, but not directly associated with production.   Examples including payroll, sales commissions, employee benefits, taxes.

These items would be used in the overhead absorption calculation

• Depreciation and Amortization: subtraction from the value of asset because of wear over time. These are figured out based on the life of an asset or how much it is used.
• Employee benefits:  those benefits directly associated with the employee’s performing activities out directly associated with production.
• Indirect Labor:  employee’s performing maintenance, repairs, cleanup around the production area in order to create products.
• Utilities: would include gas, electrical, water associated with the production activities.
• Manufacturing Consumables: gases, rods, sandpaper and other materials directly related to production activities.
• Building Expenses: expenses including rent, lease payments, mortgage and other expenses.
• Insurance: insurance that is not included in direct employee expenses, i.e. insurance on machines.

The next post will deal with how to break these expenses specific machines.

Reference: Merrill Lynch. (2003). How to Read a Financial Report.