Page 255 - Accounting Principles (A Business Perspective)

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• Net cost of purchases = Net purchases + Transportation-in.
• Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory.

• Gross margin = Net sales - Cost of goods sold.
• Income from operations = Gross margin - Operating (selling and administrative) expenses.
• Net income = Income from operations + Nonoperating revenues - Nonoperating expenses.
Each of these relationships is important because of the way it relates to an overall measure of business
profitability. For example, a company may produce a high gross margin on sales. However, because of large sales
commissions and delivery expenses, the owner may realize only a very small percentage of the gross margin as
profit. The classifications in the income statement allow a user to focus on the whole picture as well as on how net

income was derived (statement relationships).

An ethical perspective:
World auto parts corporation

John Bentley is the chief financial officer for World Auto Parts Corporation. The company buys
approximately USD 500 million of auto parts each year from small suppliers all over the world and
resells them to auto repair shops in the United States.

Most of the suppliers have cash discount terms of 2/10, n/30. John has instructed his personnel to
pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though
they are not entitled to do so. Whenever a supplier complains, John instructs his purchasing agent
to find another supplier who will go along with this practice. When some of his own employees
questioned the practice, John responded as follows:
This practice really does no harm. These small suppliers are much better off to go along and have
our business than to not go along and lose it. For most of them, we are their largest customer.

Besides, if they are willing to sell to others at a 2 per cent discount, why should they not be willing
to sell to us at that same discount even though we pay a little later? The benefit to our company is
very significant. Last year our profits were USD 100 million. A total of USD 10 million of the
profits was attributable to this practice. Do you really want me to change this practice and give
up USD 10 million of our profits?

Analyzing and using the financial results—Gross margin percentage

As discussed earlier, you can calculate the gross margin percentage by using the following formula:
Gross margin
Gross margin percentage=
Netsales
To demonstrate the use of this ratio, consider the following information from the 2000 Annual Report of
Abercrombie & Fitch.
($ millions) 2000 1999 1998
Revenues $ 1,238.6 $ 1,030.9 $ 805.2
Gross profit 509.4 450.4 331.4
Gross profit (margin)
percentage $ 509.5/$1,238.6 = 41.13% $450.4/$1,030.9 = 43.69% $331.4/$805.2 = 41.16%
Abercrombie's gross margin held at a rather high 41-43 per cent over those three years.

Accounting Principles: A Business Perspective 256 A Global Text