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Current time:0:00Total duration:12:33

Video transcript

so we have a company here let's just say it's a widget factory again or widget company and what I'm going to do is I'm going to actually write out its income statement over a given number of years what we did in the first video on this kind of series is we just did one snapshot of the income statement I think it was 2008 but here we're looking at the income statement of over a bunch of years and in this case I'm just assuming that they have very very stable revenue base that they bring in a very stable amount of revenue every year now their cost of goods I'm going to split up this time because there's two components of cost of goods so I'll just make a cost of goods category right here cogs is what but that just stands for cost of goods sold but sometimes you'll hear someone say our cogs were this or cogs were that cost of goods sold so there was there the variable costs and this video isn't a video on variable versus fixed costs but you might learn a little bit about it so there the variable cost and that's literally the actual costs of making those widgets so if the widgets are made out of stainless steel it's the cost of buying the stainless steel and maybe the energy the electricity bill of melting it and reforming it or however you have to work with stainless steel so let's say the variable cost each of these years and I'm assuming stainless steel prices don't change it's I don't know it's a it's 100 k - 100 k every year - 100 K every year and actually let's just say that the very that also includes employee costs they have people on on hourly wages that are forming these the stainless steel widgets so that incorporates everything and then the fixed cost would essentially be the cost of the factory and let's say that these factories they essentially have to build a new factory every two years or let's say they have to do major repairs to the factory every two years so let's say repairs on factory because that's part of the cost of building the widgets because if you continue to make widgets at this kind of 1 million dollars a year pace your factory has to be retooled or revamped every two years so let's put this fixed cost so the factory retooling factory retooling and most times and we'll see this when you look at a actual company's income statement they're not going to break up the variable and fixed cost within their cost of goods sold like this because really they actually want to hide it from a lot of their competitors they don't want their competitors to have too much intelligence on what their cost structure is like it could be used against them potentially or there they maybe don't want their customers to know but anyway factory retooling so the way I just described it one way to account for it is when you do the factory retooling you essentially just mark it as an expense so let's say a factory retooling cost $500,000 so let's say it's - five hundred thousand dollars but they do it every two years right so they didn't so you did it in 2005 they didn't have to do it in 2006 then they can do it in 2007 they don't have to do it in 2008 fair enough and then we have their gross profit you have their gross profit gross profit here it's let's see 1 million minus 600,000 it's 400 K and it's 900 K then it is 400 K then it's 900 K and let's say that their SGA their SGA as G native selling general and administrative expenses and I'll leave out marketing for now their SGA let's say it's another four hundred thousand dollars let's say it's a five hundred thousand every year so - five hundred and that never changes five hundred thousand every year - five hundred thousand and so their operating profit the amount of I guess pre-tax income but you know we're not considering financing either so this is their Eve it there or actually does their operating profit or their e bit so operating profit operating profit and this year is - 100 K here it's also - 100 K but then in these years they make money it's four 100 K and 400 K and then we could take this down let's say they have no interest expense so interest they have no interest expense because that's not the point of this video and then their pre-tax pre-tax expense a pre-tax profit is going to be the same thing as the operating profit so minus 100 K minus 100 K 400 K I'll make the good years in green 400 K and then let's just say there and I don't know they're in the Caribbean they don't have to pay taxes because that's not the point of this but you could figure out you could apply some tax rate to this and figure out what their net income is but the point of this is even though their business is ultra stable they do the exact same thing every year when we look at the pre-tax or the operating income or if we tax it or even at the net income we see a super lumpy business because in one year they lost $100,000 if you're looking at the business area like oh what a horrible business but then the next year they make $400,000 and then they lose $100,000 you know like gee how is that possible that you have such a sleepy stable business that's just making cogs year in year out they have the exact same amount of revenue how is it possible that their actual income is so lumpy and I think you know because you have this every other year factory retooling where they have to spend five hundred thousand dollars to essentially get their factory rebuild their factory because of all of the wear and tear that happened over the last over the last two years and so the question is is this a good way to account for it where when you have to I guess you could say buy new equipment let's say this five hundred thousand dollars just to buy actual new stainless steel shaping tools so is it a good idea to account for it only in the period that you spend it because it's not like it's not like you're only using these tools in this period in that period you're using these tools throughout the period so the the answer is well no no it's not a good idea because the whole purpose of accounting is to give the the person reading the the income statement this in this case as accurate a picture of the actual state of the business as possible and this in my opinion isn't an accurate picture where creates this huge lumpiness and it creates the impression of a volatile business even though it's a super super stable business so what you do instead of just saying oh I had to buy $500,000 worth of equipment in 2005 so I literally put a $500,000 expense there and I didn't have to do that in 2006 so I have no expense had to do it in 2007 so I put the expense instead of doing that what you do is I'll put the balance sheet down here so whatever the balance sheet was in 2000 whoops so I'll just draw the left-hand side well actually I draw both hand sides of the balance sheet so the assets so in 2000 and I want to make that a thicker line so in 2000 end this is the asset side of the balance sheet and I'll just just so you don't get confused there's always a liability side of the balance sheet as well so in 2007 maybe before I spent the $500,000 right right when I do it I probably had $500,000 of cash sitting here so let me write that down so I have cash but just put a see their cash 500k and instead of just using this as an expense and we'll go in the future on kind of how you account for things a little bit more detail on how you actually do the debits and credits but a simple way to think about it instead of using this 500 thousands expense we just transferred this 500 thousand dollars to buy an asset so when you have a when you use cash to buy an asset and that asset has a useful life that's more than just that period you're essentially capitalizing the expense or you're essentially creating that asset on the balance sheet so instead of this 500,000 just disappearing expense you say no now I have let's call it f for factory tools I have factory tools worth $500,000 and then that cash will go away so your assets will not have really changed the absolute value of the assets you will just have 500,000 going from cash to new factory tools and so this might be at the beginning of when you do it let's say this is 1 1 2007 and when you say is I'm going to use these factory tools they're usable over 2 years so what you do is you depreciate the tools so the way you think about this is instead of having factory retooling what you just well you could say factory tool instead of retooling I'll recall I'll call that depreciation depreciation I know if you can read that de PR EC ia tion depreciation so it essentially spreads out the cost of that 500 thousand dollars a year so you say I had a five hundred thousand dollar piece of capital equipment and I half of it it's useful life is two years so I use half of it in year one so instead of putting 500 thousand there the depreciation is minus two hundred and fifty thousand dollars likewise and this year no cash went out the door but my equipment got a little bit older so I used half more of it so it's two hundred fifty thousand dollars and then my equipment is worthless so this is in one one 2007 I have this this this tool that's worth five hundred thousand dollars then on one one two thousand actually what did I start this was 2005 so there's one one two thousand five then on one one 2006 I will have used half of the tool so now this balance sheet oh I recovered copy the numbers - but that's 2006 I'm going from 2005 to 2006 so now I will have used up half of it so I now have this if I according to the accounting this equipment is no longer worth five hundred thousand dollars it's now worth two hundred and fifty thousand dollars you know that actually might make sense maybe if I were to sell into the open market someone might say you know what I'm only willing to pay 250 thousand dollars because you've already used it for a year it only has one year of useful life left so it's of two hundred fifty thousand of value to me and then the other 250,000 essentially went to an expense called depreciation which was right there so every year you're going to have this asset go down on the balance sheets by two hundred fifty thousand dollars and then so here you would go the asset would be worth at the beginning this year the assets worth $500,000 so I'll write that up here so this is what the assets value I'll do it in I'll do it in this orange color so over here right let's say you did it right at the beginning of the year the assets worth five hundred thousand now it's where it's two hundred fifty thousand now the assets worth zero but at the beginning of this year you buy a new asset worth five hundred thousand then it's worth two hundred fifty thousand again and the way this is just a I guess an arguably long-winded way of saying that the way you account for this is you spread out the cost over time over its useful life and this spreading out is called the depreciation of an asset and I'm running out of time in this video and I'll cover it in the next but you might have also heard of the word of amortization amortization is to spread out a non tangible cost over a period of time so for example depreciation this was factory equipment and it gets old as I use it so I spread out its cost that's what depreciation does and it accurately reflects what's actually happening in the business you know it's not like I didn't have any cost here I did have costs I am using an asset up so therefore I put it down there amortization is the exact same thing as depreciation all but it applies to things that aren't equipment it applies to and I'll do it in the next video but let's say I had a one big expense in terms of I had to pay a bunch of fees to the bank but the the benefit of those fees are going to be over time then I would amortize those fees I'll do that in the next video anyway hopefully you found this vaguely useful