Income Statement

[Krithika]

Hi,

I have a doubt regarding how some of the items in the trial balance to be treated:

Salaries and Wages

When simply given this way, without mentioning whether it is wages of manufacturing staff or others, how should we treat it?

Should we consider this under "cost of sales" or under "operating expenses" ? (as this would affect the gross profit figure)

Rent of factory

Again, should this item be treated as a "cost of sales" or "operating expense"?

Regards,
Krithika

 

[Margaret Wood]

The Core Reading says that three main items should be included in the "cost of sales". These are:

1. the cost of materials and components used
2. wages and salaries of production staff
3. depreciation.

These are deemed to be the main costs that are directly involved in producing the goods that have been sold.

Other costs are deemed to be "overheads", ie not directly related to production. Under this heading, Core Reading puts administrative costs and distribution costs.

If the exam question includes the items listed by Core Reading, then it is sensible to put them where the Core Reading says they should be! However, if other cost items are included in the question, you will have to make a judgement about whether the cost varies directly with output or whether it is an overhead.

For example, the rent of a factory doesn't depend directly on the level of output produced so that should be an overhead. Wages and salaries are a bit trickier as some are related to output, eg production wages and some are not, eg admin salaries. If the question doesn't tell you what sort of wages and salaries we're dealing with, and you have no other hint, eg the type of company we're dealing with, then it doesn't really matter how you treat them. If wages and salaries are split into two items, I would tend to put wages in the cost of sales and salaries in the overheads.

 

[Walrus]

"the rent of a factory doesn't depend directly on the level of output produced so that should be an overhead"

Could you say the same about the depreciation of a factory that the company owns? If a company owns a factory, it will have a depreciation cost in cost of sales - so, equivalently, I would be tempted to put rent in as a cost of sale? If not, it certainly doesn't help us compare accounts easily!

 

[Margaret Wood]

The Core Reading says that we should treat depreciation as a "cost of sales". This makes life easy for us, but it can be difficult to understand.

In practice, the treatment of depreciation varies according to the reason for the depreciation. If the depreciation is caused by wear and tear, then it is clearly caused by usage and is included in the cost of sales. However, if it is caused by obsolescence, eg computers, then it is caused by the passage of time rather than usage and is often classed as an overhead.

However, just to be clear, the Core Reading says that we should treat depreciation as a cost of sales.

 

[Krithika]

Hi,

In April 2006 exam paper, for solution to Q20, I considered the depreciation of Delivery vehicles, plant and machinery all under cost of sales. But the examiner's report shows that the depreciation of Delivery Vehicles has been considered under Distribution Cost and depreciation of plant and machinery has been considered under Administration Cost.

So I ended up getting different gross profit and net profit figures. Would this make a difference in examination?

 

[freddie]

Since the Core Reading says that depreciation should be a cost of sales, I can't see how you could be penalised for treating it as such!