Problem 29 - Accounting

Question

The following income statement data (in thousands) for Dell Computer Corporation and Gateway Inc. were taken from their recent annual reports: \begin{tabular}{lrr} & \multicolumn{1}{c}{ Dell } & Gateway \\ \hline Net sales & \(\$ 35,404,000\) & \(\$ 4,171,325\) \\ Cost of goods sold (expense) & \((29,055,000)\) & \((3,605,120)\) \\ Operating expenses & \((3,505,000)\) & \((1,077,447)\) \\ Operating income (loss) & \(\$ 2,844,000\) & \(\$(511,242)\) \\ \hline \end{tabular} a. Prepare a vertical analysis of the income statement for Dell. b. Prepare a vertical analysis of the income statement for Gateway. c. Based upon (a) and (b), how does Dell compare to Gateway?

Step-by-Step Solution

Answer

Dell has more efficient costs and greater profitability than Gateway.

Step 1: Understand Vertical Analysis

Vertical analysis, also known as a common size analysis, involves expressing each item in a financial statement as a percentage of a base item. In an income statement, typically net sales is used as the base item.

Step 2: Prepare Vertical Analysis for Dell

For Dell, we express each item as a percentage of its net sales. Dell's net sales are $35,404,000. The calculations are as follows:- Net Sales: \(\frac{35,404,000}{35,404,000} \times 100 = 100\%\)- Cost of Goods Sold: \(\frac{29,055,000}{35,404,000} \times 100 \approx 82.05\%\)- Operating Expenses: \(\frac{3,505,000}{35,404,000} \times 100 \approx 9.90\%\)- Operating Income: \(\frac{2,844,000}{35,404,000} \times 100 \approx 8.03\%\)

Step 3: Prepare Vertical Analysis for Gateway

For Gateway, we also express each item as a percentage of its net sales. Gateway's net sales are $4,171,325. The calculations are:- Net Sales: \(\frac{4,171,325}{4,171,325} \times 100 = 100\%\)- Cost of Goods Sold: \(\frac{3,605,120}{4,171,325} \times 100 \approx 86.39\%\)- Operating Expenses: \(\frac{1,077,447}{4,171,325} \times 100 \approx 25.82\%\)- Operating Income (Loss): \(\frac{-511,242}{4,171,325} \times 100 \approx -12.25\%\)

Step 4: Compare Dell and Gateway

By comparing the vertical analyses: - Dell's cost of goods sold is 82.05% of its sales, while Gateway's is 86.39%, indicating Dell is more efficient with its production costs. - Dell's operating expenses are 9.90% compared to Gateway's 25.82%, showing Dell has much lower relative operating expenses. - Dell has a positive operating income of 8.03%, whereas Gateway has an operating loss of 12.25%, highlighting better overall profitability for Dell.

Key Concepts

Income Statement

An income statement is a crucial financial document that outlines a company's financial performance over a specific period. It records revenues, expenses, and profits, providing insights into how well the company is doing financially.
Think of it as a report card showing how much money came in from sales, what costs were incurred, and what's left as profit. This helps businesses and investors make informed decisions. In the context of vertical analysis, each line item in the income statement is evaluated as a percentage of total net sales. This allows for an easy comparison of different sized companies or changes over time. Common elements found in an income statement include net sales, cost of goods sold, operating expenses, and operating income. Understanding each line's contribution provides a clearer picture of efficiency and profitability. For example, Dell and Gateway's income statements were assessed using vertical analysis in the exercise. Dell's net sales acted as the base item, and so did Gateway's net sales, allowing each company's results to be understood proportional to their respective sales.

Operating Income

Operating income gives a clear view of a company's profitability from its core business operations. It shows how efficiently a company generates profit from its operations before taking into account taxes and interest expenses. This figure is derived by subtracting operating expenses and the cost of goods sold from the net sales. It can highlight the company's operational efficiency. A high operating income suggests that a company is managing its core business costs effectively. With Dell, the operating income was 8.03% after performing vertical analysis. This indicates a healthy operating performance. In contrast, Gateway recorded an operating loss of 12.25%.
This disparity highlights clear efficiency and profitability advantages in Dell's favor, pointing to better management of its business operations compared to Gateway.

Cost of Goods Sold

The cost of goods sold, or COGS, represents the direct costs attributable to the production of goods sold by a company. This covers all expenses directly tied to the creation of products, such as material and labor costs.
Lower percentages of COGS in relation to net sales generally point to better efficiency in production. To calculate COGS vertically, it is expressed as a percentage of net sales. This measure allows companies to understand how much of their sales revenue is being consumed by production costs. For Dell, COGS is 82.05% of net sales, whereas Gateway has a higher COGS at 86.39%. This suggests that Dell uses its resources more efficiently and keeps production costs lower relative to sales.

• Effective resource utilization can aid in improving profit margins.
• Consistent monitoring of COGS can help identify areas where a company may enhance efficiency.

Operating Expenses

Operating expenses encompass all costs that a company incurs during its regular business activities, excluding the costs associated with production, which fall under COGS. These may include rent, utilities, sales, and administrative expenses. Reducing operating expenses while maintaining quality and service levels can significantly improve a company's profitability. Through vertical analysis, these expenses are expressed as a percentage of net sales, enabling organizations to track them relative to earnings and compare with industry peers. In the comparison between Dell and Gateway, Dell's operating expenses account for just 9.90% of its net sales.
Meanwhile, Gateway's operating expenses take up 25.82%. This considerable difference elucidates how Dell more effectively manages its day-to-day expenditures, supporting better profitability.

• Monitoring operating expenses is essential for sustaining financial health.
• Keeping these expenses in check ensures better operational control, leading to higher potential profit margins.