How to calculate and apply the payback period to capital budgeting decisions
IIn this presentation we will take a look at some of the components of a manufacturers income statement comparing and contrasting where a manufacturers income statement may differ from a service company or a merchandiser where a manufacturer
A company that makes the inventory could differ from a service company that has no inventory or a merchandiser who just purchases and sells inventory
Rather than making the inventory part of that will be the calculation of the cost of goods sold
So clearly one of the differences we're going to have from a manufacturer to a service company will be related to inventory and the major difference between the inventory accounts on the income statement is the cost of the inventory the expense related to the inventory at the point of sale that being the cost of goods sold
Therefore a service companies often going to have just a single step income statement where we group up revenue and then we group up all of expenses and we subtract out to get the net income for a merchandiser that has inventory and a manufacturer that makes inventory
We're also going to have the cost of goods sold
The cost of goods sold calculation will be very similar but it will have some differences that we want to note from a merchandising company to a manufacturing company
Very important formula we want to just memorize this formula
We'll be using this formula many different ways
So the merchandising company if we thought about the merchandise or company first and then convert and say okay what do we need to change to go to a manufacturing company to calculate cost of goods sold for a merchandiser
A company that just purchases and sells inventory doesn't make the inventory the cost of goods sold calculation would be the beginning inventory what was inventory at the start of the period the start of the month or the year and then we're going to add to it purchases
We know what the purchases are because we actually paid for the inventory that we bought and therefore there's no real estimation in terms of the purchases that's going to give us the cost of goods available for sale
That's what we could have sold during the time period
If it's a month we could have sold this many units
How many did we sell to do that
And this is kind of a periodic calculation
And again we can we're going to use the cost of goods calculation whether we use a periodic system or perpetual system often times
But note when the format of it is kind of more of a periodic type of format because we're saying this is the cost of goods available for sale and then we're going to subtract out Indian inventory which we can imagine we got through a physical count
We count the inventory at the end as we would in a periodic inventory system
And therefore if this is the inventory we had available for sale the inventory we could have sold
And this is the inventory that we have not yet sold
The difference between those two is what we have sold on a cost basis and that's going to be the cost of goods sold
That's going to be the expense
That's what will be reported on the income statement as an expense
The most important expense for a merchandise or a manufacturer
The cost of the inventory that we are selling now if we look at a manufacturer or we can say okay how can we convert this in order to deal with a manufacturer rather than a merchandiser we're gonna have that same beginning inventory and then rather than having purchases however we're going to add to it cost of goods manufactured
So we didn't purchase these goods obviously we did purchase the materials but we we're going to have cost of goods manufactured which is going to include what we made in terms of not just materials but what we made in terms of the work that we put in the direct labor and the overhead that's going to be put in there now
This number you might be saying well we're where we're going to get that number we're going to have to figure that out through our production process and once we do that
However this is the number that we're going to use other and it's not going to be purchases
So that's where the big difference is you can see that they're basically you know similar in that purchases is obviously the activity that we had happen through our merchandise company and they manufacturer what had happened is that we not only purchased materials but we made them into inventories that's the cost of goods manufactured that then gave us the cost of goods available for sale and then we're going to do the same
Subtract out the Indian finished goods inventory
So what had been completed in the finished goods and that will give us all our cost of goods sold
So you can see the two formulas are going to be very similar
Now note that you can use this formula not just for the calculation of cost of goods sold
I mean if there's a book question expressing multiple choice questions will often move maneuver things round so that we'll have to solve for different types of items here
And that's one way that a multiple choice question can be used in order to to to test conceptual components
And so note that any of these or any of these components of the formula a multiple choice question Could Ask For meaning the multiple choice question could give us beginning inventory and not be asking for beginning inventory and give us the rest of the data
What we do not want to do is try to memorize a formula to get to beginning inventory because all we're doing is adjusting the algebra what we want to do is write down this formula and say that OK we have cost of goods sold and we can back into the beginning inventory
The same would be true for if they gave us all this information but not the cost of goods manufactured
We're not going to rewrite another formula to figure out what the cost of goods manufactured is we're going to use this formula and just use algebra to say OK
This is the unknown and now I know everything else
This is the unknown
So any any question that's going to be related to any of these items could be ending inventory of course as well
You want to just be able to write down this formula and then apply out whatever you need
And also note of course that this is a sub soil
This is a subcategory
So sometimes you can actually if you want to simplify your algebra then you can eliminate this item say beginning inventory plus cost of goods sold minus Indian inventory gives us cost of goods available for sale and then if you if you do that then they can ask for
If they give you the other components they can eliminate any one of these and ask you for that and what you want to do is is write down this formula OK and say this is the unknown I don't know that one
So now I'm going to do what I gotta do to make that number right if I know this number
If I know this number that I can do what I gotta do to make that number what it needs to be
If we look an example here we're gonna say if if beginning inventory happen to be fourteen thousand we're going to add to it our cost of goods manufactured what we made we're going to say two hundred thousand here
That gives us what's available
Two hundred and fourteen thousand
Now of course note that we're talking about dollars
This is a cost of what we made here
So we're not talking about units we're gonna have to convert that into dollars and that's a bit you know something that more confusing than we might
First things to do that but then we have the cost of available for sale cost goods available for sale and then we're going to subtract out what's still in Indian inventory which we can get from typically a physical account
Now again this physical count is in dollars
So we have twelve thousand dollars worth at the physical count would be in units which we would have to then convert it some way to dollars if this is the number of dollars worth of inventory we had available for sale in the month
And this is how much has not yet been sold
The difference between the two then is going to be what had been sold which we're gonna say is cost of goods sold
This then is what will be reported on the income statement reducing growth reducing sales by the cost of goods sold to get the gross profit and ultimately to the net income
This is gonna be our most important expense on the income statement
If we are a manufacturer because it's gonna be the highest cost typically the things that we make if we make stuff is going gonna be the highest cost of what we do
And therefore we're going to break it out separately most of the time and have the sales minus the cost of goods sold given us that subcategory of gross profit on the income statement
A company that makes the inventory could differ from a service company that has no inventory or a merchandiser who just purchases and sells inventory
Rather than making the inventory part of that will be the calculation of the cost of goods sold
So clearly one of the differences we're going to have from a manufacturer to a service company will be related to inventory and the major difference between the inventory accounts on the income statement is the cost of the inventory the expense related to the inventory at the point of sale that being the cost of goods sold
Therefore a service companies often going to have just a single step income statement where we group up revenue and then we group up all of expenses and we subtract out to get the net income for a merchandiser that has inventory and a manufacturer that makes inventory
We're also going to have the cost of goods sold
The cost of goods sold calculation will be very similar but it will have some differences that we want to note from a merchandising company to a manufacturing company
Very important formula we want to just memorize this formula
We'll be using this formula many different ways
So the merchandising company if we thought about the merchandise or company first and then convert and say okay what do we need to change to go to a manufacturing company to calculate cost of goods sold for a merchandiser
A company that just purchases and sells inventory doesn't make the inventory the cost of goods sold calculation would be the beginning inventory what was inventory at the start of the period the start of the month or the year and then we're going to add to it purchases
We know what the purchases are because we actually paid for the inventory that we bought and therefore there's no real estimation in terms of the purchases that's going to give us the cost of goods available for sale
That's what we could have sold during the time period
If it's a month we could have sold this many units
How many did we sell to do that
And this is kind of a periodic calculation
And again we can we're going to use the cost of goods calculation whether we use a periodic system or perpetual system often times
But note when the format of it is kind of more of a periodic type of format because we're saying this is the cost of goods available for sale and then we're going to subtract out Indian inventory which we can imagine we got through a physical count
We count the inventory at the end as we would in a periodic inventory system
And therefore if this is the inventory we had available for sale the inventory we could have sold
And this is the inventory that we have not yet sold
The difference between those two is what we have sold on a cost basis and that's going to be the cost of goods sold
That's going to be the expense
That's what will be reported on the income statement as an expense
The most important expense for a merchandise or a manufacturer
The cost of the inventory that we are selling now if we look at a manufacturer or we can say okay how can we convert this in order to deal with a manufacturer rather than a merchandiser we're gonna have that same beginning inventory and then rather than having purchases however we're going to add to it cost of goods manufactured
So we didn't purchase these goods obviously we did purchase the materials but we we're going to have cost of goods manufactured which is going to include what we made in terms of not just materials but what we made in terms of the work that we put in the direct labor and the overhead that's going to be put in there now
This number you might be saying well we're where we're going to get that number we're going to have to figure that out through our production process and once we do that
However this is the number that we're going to use other and it's not going to be purchases
So that's where the big difference is you can see that they're basically you know similar in that purchases is obviously the activity that we had happen through our merchandise company and they manufacturer what had happened is that we not only purchased materials but we made them into inventories that's the cost of goods manufactured that then gave us the cost of goods available for sale and then we're going to do the same
Subtract out the Indian finished goods inventory
So what had been completed in the finished goods and that will give us all our cost of goods sold
So you can see the two formulas are going to be very similar
Now note that you can use this formula not just for the calculation of cost of goods sold
I mean if there's a book question expressing multiple choice questions will often move maneuver things round so that we'll have to solve for different types of items here
And that's one way that a multiple choice question can be used in order to to to test conceptual components
And so note that any of these or any of these components of the formula a multiple choice question Could Ask For meaning the multiple choice question could give us beginning inventory and not be asking for beginning inventory and give us the rest of the data
What we do not want to do is try to memorize a formula to get to beginning inventory because all we're doing is adjusting the algebra what we want to do is write down this formula and say that OK we have cost of goods sold and we can back into the beginning inventory
The same would be true for if they gave us all this information but not the cost of goods manufactured
We're not going to rewrite another formula to figure out what the cost of goods manufactured is we're going to use this formula and just use algebra to say OK
This is the unknown and now I know everything else
This is the unknown
So any any question that's going to be related to any of these items could be ending inventory of course as well
You want to just be able to write down this formula and then apply out whatever you need
And also note of course that this is a sub soil
This is a subcategory
So sometimes you can actually if you want to simplify your algebra then you can eliminate this item say beginning inventory plus cost of goods sold minus Indian inventory gives us cost of goods available for sale and then if you if you do that then they can ask for
If they give you the other components they can eliminate any one of these and ask you for that and what you want to do is is write down this formula OK and say this is the unknown I don't know that one
So now I'm going to do what I gotta do to make that number right if I know this number
If I know this number that I can do what I gotta do to make that number what it needs to be
If we look an example here we're gonna say if if beginning inventory happen to be fourteen thousand we're going to add to it our cost of goods manufactured what we made we're going to say two hundred thousand here
That gives us what's available
Two hundred and fourteen thousand
Now of course note that we're talking about dollars
This is a cost of what we made here
So we're not talking about units we're gonna have to convert that into dollars and that's a bit you know something that more confusing than we might
First things to do that but then we have the cost of available for sale cost goods available for sale and then we're going to subtract out what's still in Indian inventory which we can get from typically a physical account
Now again this physical count is in dollars
So we have twelve thousand dollars worth at the physical count would be in units which we would have to then convert it some way to dollars if this is the number of dollars worth of inventory we had available for sale in the month
And this is how much has not yet been sold
The difference between the two then is going to be what had been sold which we're gonna say is cost of goods sold
This then is what will be reported on the income statement reducing growth reducing sales by the cost of goods sold to get the gross profit and ultimately to the net income
This is gonna be our most important expense on the income statement
If we are a manufacturer because it's gonna be the highest cost typically the things that we make if we make stuff is going gonna be the highest cost of what we do
And therefore we're going to break it out separately most of the time and have the sales minus the cost of goods sold given us that subcategory of gross profit on the income statement
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