The Fundamental Flaw in Financial Reporting

September 13, 2022

Just about every income statement I have ever seen starts with sales dollars, and almost all readers of financial statements discuss their results with some reference to sales, such as “we had a good year last year—sales were up 15%, and we are now a $50 million dollar company.” But all sales are not equal, are they?

Companies record revenue from various sources and lines of business. Some can be considered the recoupment of costs, such as freight or tooling, although they may be marked up. Others are byproducts of a manufacturing process such as the sale of scrap. Companies charge customers for items that they produce and for items that they purchase and resell. Finally, there is often a great diversity in the product lines that a company offers—some are the result of very labor-intensive endeavors, and others are more machine-centric—and there is often a great disparity in the profitability of the items sold. Yet every income statement begins with sales.

The Financial Accounting Standards Board (FASB) has been acutely interested in how companies recognize revenue for quite some time, and in May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), which establishes the principles to report useful information to users of financial statements about the nature, timing, and uncertainty of revenue from contracts with customers. This change required every company that financial statements in accordance with generally accepted accounting principles (GAAP) to reevaluate revenue recognition, and for many companies in many different industries the restatements that resulted from this pronouncement were enormous. This pronouncement caused companies to disaggregate sales into their component parts, so that a computer that was sold with bundled software and a maintenance contract would have to record three different streams of revenue that would be recognized in differing amounts over differing time periods.

Similarly, when a converter records a sale, they are probably recording four or five different steams of revenue that all get aggregated into something called “sales.” Let’s say a converter sells a point-of-purchase display that is fully packed out and delivered to the customer. The converter has purchased tooling for the order, has bought some display components that were manufactured by someone else, has converted the board into display components, packed out the display with the customer’s product, and delivered it either in their own trucks or by common carrier. The order was for 2,000 displays, the customer was charged $75 per display, and the accounting department recorded a $150,000 sale. Very neat and clean, right?

The reality is a lot messier, though. What really happened is that the customer was charged $10,000 for tooling that cost $7,500; $8,000 to assemble the displays, with a labor cost of $5,000; $22,500 to pack out the displays, with a labor cost of $12,000; $2,500 for delivery; and therefore, only $107,000 for the manufacture of the displays themselves. Yet the books will show a sale of corrugated displays of $150,000. The reason for this is that the customer wants one price for the displays, the estimating system does not ordinarily break out the components of the sale, and the accounting system is not set up to look for these breakdowns anyway. So, the short answer is that it would take more people time or custom programming time to achieve this.

In addition to this issue, most companies sell a fairly varied product line: Some they manufacture, some they purchase and resell, and others are a combination of manufactured and purchased components. They sell products to end users, products to brokers, and products to other manufacturers. The margins on all these types of sales vary greatly, and the mix may change greatly from period to period. So why, then, do all financial statements start with sales? I suppose one can say that it is an indication of the overall volume of the transactions that flow through the entity, and it is an objective measurement. But does it really tell the story of what went on during the period? The other issue is: If the statement doesn’t start with sales, what should it start with?

The short answer is margin—contribution margin, to be more specific—and contribution margin by major lines of business, to be even more specific. Let’s consider the two income statements in the table below.

Both statements have the same amount of contribution margin and expenses, and both show the same level of profits. The first one begs the question, “Why did profits go down when sales increased?” What you can see from the first statement is that margins went down and costs went up. In reviewing the second statement, it is readily apparent that the company had less manufactured margin, less assembly and fulfillment margin, and the same margin from the sale of purchased products. Margins are generally higher from manufactured sales and value-added work, such as assembly and fulfillment, and generally lower from the brokerage activities.

The other nuance in the second statement is that all the expenses (fixed costs) are expressed as a percentage of margin, not as a percentage of sales. Since margin is an indication of how much money is available to pay for fixed costs, many analysts prefer measuring them as a percentage of margin. By switching to margin as the top figure on the statement, you can run the P&L by starting with margin from customers and listing the top 10 or 20 customers to compare the margins received from them and the change from the prior period. You can start the P&L by margin from salespeople and margin from customers in different industries and break out the trade accounts. The possibilities are almost endless in terms of how you look at your business and much more descriptive of what went on during the period. To accomplish this, you may need to make some changes to your general ledger and do a better job of reconciling your actual results to the results in your estimating system, but the benefits to your reporting systems can be enormous. So in the future, start thinking more in terms of margin dollars than sales dollars, because at the end of the day, margin dollars are available to pay for everything else, while sales dollars may or may not tell the full story.