A:

In order to operate and make money, a company must spend money. Revenue - the dollar amount of sales - can be seen on a company's income statement. From there, various expenses are deducted such as cost of goods sold and marketing. But it is the earnings figure, or net income, that reveals what the company retains from all its sales. The incongruity arises from the steps a company takes to go from sales to earnings. If sales are rapidly rising but earnings are falling, it means costs are growing faster than earnings.

sales1.gif

As can be seen above, sales have risen 100%, but in order to generate these sales, the company raised its marketing efforts by 200% for a 243% increase in COGS. These higher costs outweigh the increased sales, which lead to a 9% decrease in earnings. Here are some possible reasons why an increase in revenue can hurt earnings:

  • Operating Expenses - This is a company's overhead, or the cost of doing business. As a company attempts to boost sales, it may have to pay more employees, lease more office space or buy new equipment to increase production. Unless a company raises its productivity, it may, by increasing sales, simply become bloated. This will lower its margins, which leads to lower earnings.
  • Marketing Costs - Advertising, free trials, discounts and other promotional material can all be used to increase sales. While these tactics are often effective, they cost money, ultimately affecting the bottom line.
  • Lower Prices - When a company lowers the price of its product, it can stimulate greater sales. While the price is lower, the amount sold may greatly increase, which lifts revenue. However, if costs are not going down, the company's margins will be smaller, leading to lower earnings.

It is important to recognize the distinction between sales revenue and earnings: while earnings may rise, so could expenses. Ideally, revenues and earnings should be moving in the same direction. Decreasing revenues and increasing earnings mean greater profit margins. Higher revenues and lower earnings means that income is being eroded by expenses.

It should be noted, however, that increased revenue amid lowered earnings is not uncommon. In maturing industries, companies must fight for their market share. This can mean price wars, huge marketing campaigns and other promotions that hurt margins. Many companies allow lowered earnings because taking a loss is necessary to expand customer base, which eventually helps to recoup losses.

(To learn more, see Understanding The Income Statement.)

RELATED FAQS
  1. What is the difference between earnings and revenue?

    Understand how a company makes revenue and how it makes earnings. Learn the difference between revenue and earnings and how ... Read Answer >>
  2. For a company, is it more important to lower costs or increase revenue?

    Examine the question of whether a company's desire for increased profitability is better served by focusing on cutting costs ... Read Answer >>
  3. How is revenue related to retained earnings?

    Learn what business revenue is and how it relates to retained earnings. See how accountants calculate these key figures and ... Read Answer >>
  4. How is the bottom line increased or decreased?

    Find out about the bottom line and how changes in sales revenue or expenses can cause a company's net profit to increase ... Read Answer >>
  5. What is the difference between earnings and income?

    See how earnings and income are different and when they are used in relation to personal finance versus a business' financial ... Read Answer >>
  6. What components are factored in determining net sales?

    Understand the key components that factor into determining a company's net sales. Learn about the underlying drivers of those ... Read Answer >>
Related Articles
  1. Investing

    Understanding the Income Statement

    The best way to analyze a company—and figure out if it's worth investing in—is to know how to dissect its income statement. Here's how to do it.
  2. Investing

    IBM Stock: An Earnings Case Study

    Learn the main drivers behind IBM's earnings model and why analysts predict a decline in 2016 followed by a strong recovery in 2017.
  3. Investing

    The Most Important Metrics For Earnings Season

    Knowing how to read an earnings report can help investors decide which stocks to buy.
  4. Investing

    Understanding the Top Line

    Top line refers to a company’s gross sales without any reductions for discounts or returns.
  5. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  6. Investing

    What are Earnings?

    The amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year.
  7. Investing

    Understanding Profit Metrics: Gross, Operating and Net Profits

    Rather than relying solely on net profit figures to evaluate a company's performance, seasoned investors will often look at gross profit and operating profit as well.
  8. Investing

    Contribution Margin

    Contribution margin is a cost accounting concept that allows a company to determine the profitability of individual products.
  9. Investing

    Net Sales

    Net Sales is an accounting term used to analyze a company's performance. It is the sales revenue that remains after deducting for product returns, damaged or missing products, and discounts. ...
RELATED TERMS
  1. Revenue

    The amount of money that a company actually receives during a ...
  2. Quality Of Earnings

    The amount of earnings attributable to higher sales or lower ...
  3. Earnings

    The amount of profit that a company produces during a specific ...
  4. Gross Sales

    A measure of overall sales that isn't adjusted for customer discounts ...
  5. Cost Of Revenue

    The total cost of manufacturing and delivering a product or service. ...
  6. Top Line

    A reference to the gross sales or revenues of a company, or an ...
Hot Definitions
  1. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  2. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
  3. Retained Earnings

    Retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested ...
  4. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables. ...
  5. Dark Pool

    A dark pool is a private financial forum or exchange for trading securities.
  6. Quadruple Witching

    The expiration date of various stock index futures, stock index options, stock options and single stock futures. All stock ...
Trading Center