For the beginning investor, one of the most important keys to learning about a business is understanding its financial statements. And of the three major statements -- the balance sheet, income statement, and statement of cash flows -- the income statement is usually the best place to start.
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After all, earnings are the foundation of stock valuation, and understanding how and why a company makes (or doesn't make) a profit is central to further analysis of the company as an investment.
On an income statement, your attention will be drawn to the company's expenses, as revenue generally makes up just one line item on the document -- with a few exceptions, revenue comes primarily from sales, which do not need further explanation. The cost structure, however, is more complicated, and therefore important for investors to understand.
Though the income statement does not say so directly, expenses are made up of two key categories: fixed costs and variable costs.Fixed costs, like rent, do not change from month to month, while variable costs, such as the cost of goods sold, are directly tied to sales. Costs that contain aspects of both fixed and variable costs, like utilities, are called mixed costs.
An example of a business with largely variable costs would be a lemonade stand -- lemons, sugar, water, ice, and cups. The cost of the business would be directly correlated with each cup of lemonade sold. An equipment rental business, on the other hand, would be made up of mostly fixed costs, as the cost to buy and own equipment is the same whether or not it gets rented.
To examine this concept further, let's take a look at a couple real-world examples.
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Chipotle Mexican Grilloffers a relatively straightforward business model. The economics of a restaurant business are simple, and unlike many fast food chains, Chipotle does not franchise, so all of its sales and expenses are a direct result of operating restaurants.
The key line items on the 2014 Chipotle income statement are:
1. Revenue -- $4.1 billion
2. Food, Beverage, and Packaging Costs -- $1.4 billion
3. Labor costs -- $900 million
4. Occupancy costs -- $230 million
5. General and Administrative costs -- $273 million
Of the four cost categories above, the first two would be considered variable costs, while the bottom two are fixed. Based on those numbers, variable costs make up a much larger portion of expenses than fixed costs. That means that Chipotle's overall profit margin should be relatively stable, as its costs tend to fluctuate with sales.
Six of one, a half-dozen of the other
There is not necessarily an advantage to fixed costs or variable costs. Having high fixed costs gives a business increased operating leverage, meaning an increase in sales will have a greater effect on profits (e.g., 20% jump in sales could lead to a 50% increase in profits). However, high fixed costs also leave a business at risk, as a downturn in sales will have an outsized effect and could quickly result in losses.
For a look at a business dependent on fixed costs, Netflix offers a good example. The video streamer pulled in $5.5 billion in revenue last year, $3.7 billion of which went to the line item "cost of revenues," which management says is mostly content expenses, or what it pays to license the movies and TV shows its customers watch. Those are a form of fixed costs.
Not surprisingly, the majority of Netflix revenue goes to content licensing and development, and the fixed nature of that cost explains why its earnings are so erratic from quarter to quarter and year to year. It also shows why Netflix highlights its subscriber figures in each report. Additional subscribers are highly profitable for Netflix, as its costs almost nothing to expand distribution to a new viewer. Subscription businesses tend to be built on fixed costs, as the cost to produce whatever content is being sold is the same whether there are one hundred subscribers or one million of them.
The total cost equation
When relevant, it helps to compare the expenses and margins of a business with those of its competitors. Netflix has no pure play competition in streaming, making a comparison difficult, but Chipotle has plenty of peers in the restaurant industry. A closer look shows that Chipotle's restaurant-level operating margin is around 27% and significantly higher than much of the competition. That means Chipotle is successfully controlling its costs, both variable and fixed, in order to drive greater value for its shareholders.
Once you understand the cost equation as an investor, the next step is to compare the figures with those of industry peers. Lower cost percentages, i.e. higher margins, compared to the industry are one of the best indicators of a superior, well-run company.
The article Total Cost Formula: How to Break Down Business Expenses originally appeared on Fool.com.
Jeremy Bowman owns shares of Apple, Chipotle Mexican Grill, and Netflix. The Motley Fool recommends Apple, Chipotle Mexican Grill, and Netflix. The Motley Fool owns shares of Apple, Chipotle Mexican Grill, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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