What are the direct costs or Costs of Goods Sold? Let's understand with an example
Cost of goods sold or cost of service is the second most important thing to look at in an income statement - let us see why and how?
I am Furqan Punjani and I have been doing financial analysis work for 15 years now! This short newsletter - Statement Secrets is to help investors become better at looking at financial statements in an easy and fun way.
Subscribe here:
Every Friday @ 11 am Pakistan Standard Time
We also write Investletter - a letter that is decided for Pakistanis to make their financial decisions better. Check it out here!
We know what are sales/revenue and how to look at them.
We also know what is the cost of goods and how to see its breakup (revision link)
Now we come to the first profit we see in an income statement. it’s called Gross Profit.
It looks like this ⬇️
- First, we will see What are gross profits?
- 2 ways to see them and finally
- A simple analysis of these numbers.
Let’s start
What is Gross Profit?
It is the difference between how much a company sold its products for and how much direct cost was required to make it.
If it is positive this means that the company made a profit and if it’s negative then the company made a loss.
There is no science to it, just simple math
Example:
Sales = Rs100,000
Cost = Rs90,000
Gross Profit =Rs10,000
Unlike sales and cost where we had to go in detail to see the breakup, here we don’t have any breakup.
Two ways to look at the gross profit
1. A simple change from the last year
Let us look at the same example again
The gross profit is up 137%
Formula: Latest Year divided by Last Year - 1 ×100
Or
Rs. (2045/864) = 2.36
2.36 -1 =1.36
1.36 ×100 = 136%
This means that the company has more than doubled its gross profit. Awesome right?
Not too fast!
2. Gross Profit margin analysis
Look at the sales number again!
The sales are also up from Rs2.6bn to Rs5.1bn.
How do we know that the change is coming just because they sold more products or made more money selling each unit?
Example:
- Did they sell say 1000 more units vs the last year
- They sold all the units at more prices leading to more profits
Looking at the simple change doesn’t help.
So what we do is see the percentage of profit.
We do this by dividing the gross profit by sales numbers.
Latest year: 2045 / 5179 = 39%
Last year: 864 / 2623 = 33%
We have hit a gem!
The gross margins are better in the latest year vs the last year
This means that the company was able to charge more for the goods and make more money on each of the items they sold.
This is all you should know about the gross margins as a reader of the financial statement, student or investor.
Click on the button below to see a sample analysis of this company covering all the topics we have learned so far.
Analysis of Pakistan Aluminum Beverage Cans Limited
Let us do a simple analysis of PABC’s 1Q2023 financial results using whatever we have learned so far i.e. sales, sales growth, primary cost or cost of goods sold and gross margins.
This is whats relevant to us right now!
- PABC’s sales for the first quarter have gone up by 97% i.e. from Rs2.6bn in 1Q2022 to Rs5.1bn in 1Q2023.
- Sales have almost doubled which is a great thing but as we talked about it before also, we need to see where are these sales coming from. Is this coming from increasing the price of the product they sell or they have sold more units? (selling more units is considered better than increasing prices).
- Since this is a quarterly result we don't have any breakup to see units sold.
- This tells us one more thing about financial statements; companies don't disclose breakups in the quarterly reports.
- There is a way around which is to read their director report but PABC hasn't disclosed anything about volumes there too.
- Like Sales, the Cost of Goods sold has also gone up. From Rs1.7bn in 1Q2022, it has come up to Rs3.1bn i.e. a jump of 77%
- This jump is lower than the growth in sales (97%) which means that the company was able to control its cost vis-a-vis sales.
- Here again, there is no breakup for us to see what the main reason for the cost going up was.
- The Gross profits have gone up by 136% (also discussed above).
- But the best part is that the gross margin has gone up. This means that the sales increase was higher than the cost increase leading to more money overall for the company.
- Gross Margins were 33% in 1Q2022 and now they have come up to 39%!
Overall speaking, PABC grew its sales, and profit margin in the 1Q2023. The growth is phenomenal.
If I were an Investor in PABC
If I was an investor in PABC I would have followed the company more closely.
- I would have read its director report to see where the sales growth is coming from. Have they done any kind of expansion in the plant to make more units?
- Is it sustainable or will the growth die down?
- What will be its tentative earning or EPS (don’t worry we will come this soon) to see if the stock is trading cheaply to buy or if it has already gone up after investors saw such exceptional results?
Next
Previous Issues
Liked it? We send a crisp version of this article through email every Friday 11 am Pakistan Standard Time! Join us!
Related Posts
Statement Secrets? Financial Analysis for non accounting professionals
This series is perfect for anyone who wants to understand financial statements but isn't a finance professional or investor.