Outline:

  • Revenue refers to the money a business makes;
  • But there are costs associated with providing the goods or services;
  • Subtracting the cost of revenue from the total revenue, we get the gross profit.

The balance sheet provides a snapshot of a business’s financial position at a point in time.

Now, imagine you’re running a business that looks great from its balance sheet because of a highly profitable past, but has become unprofitable.

How do you know it has become unprofitable? You look at the income statement and asses what the revenues are. What is the business' income?

It will give you a closer look at what’s been happening.

The income statement

The income statement is a way for you to measure a business’s performance over a set period of time. Total revenue is one part of the income statement.

Total revenues simply refers to the money a business has made.

Let’s use [Amazon](http://www.nasdaq.com/symbol/k/financials?query=income statement) as an example.

Amazon’s total revenue comes from Amazon.com (both US and international businesses), Amazon Web Services, as well as other revenue generating subsidiaries of Amazon like Zappos.

For companies like Amazon, it can be hard to understand where revenues actually come from. As different entities under Amazon may generate revenue at different points. For example, when does Amazon Web Services record revenue if they sell the service to Amazon.com?

Further, the international nature of Amazon’s business make it more complex.

Are overseas shipments recorded in USD or the country’s native currency?

Is Amazon.com just providing services by delivering goods from a warehouse to customers, or is it producing its own goods too?

Cost of revenue

Once total revenue is established, accountants will subtract any deductions included under the cost of revenue.

The cost of revenue is the total cost of manufacturing and delivering the product or service. In other words, the direct costs associated with providing the goods or services.

This could include:

  • Materials related to a sale
  • Direct labour that contributes to a sale
  • Overhead allocated to a sold product
  • Sales call costs
  • Discount or promotional costs
  • Commissions
  • Perishable goods that diminish in value over time

For a cost to be included under the cost of revenue, it must be a direct cost associated with the goods or services provided.

By subtracting the cost of revenue from the total revenue, we get the gross profit.

Indirect costs such as salaries paid to managers, or marketing expenses are not included under the cost of revenue.

They will come under expenses.

Summary

Revenues are the total amount of money a business has made. They form a crucial part of financial analysis because they offer a way to measure of a company’s performance over a period of time. Financial analysts often see revenue as an indication of earnings quality.

Earnings quality is a measure how predictable a company’s future earnings will be. For many investors, earnings quality is important.