The Anatomy of a Profit and Loss Statement: A Simple Guide

So many names.

The first thing you need to know about a Profit and Loss Statement is that it goes by other names. The most common alias is P+L, short for profit and loss and Income Statement. You also might see it called a Revenue Statement, Earnings Statement, or an Operating Statement.

The Basic Formula

All P&Ls are based on and demonstrate a very simple formula:

Sales - Costs = Profit or Loss

Just like a Balance Sheet, the P+L is a complex demonstration of a simple accounting equation.  What makes it complicated is that there may be other names for sales. You might see sales also called revenue or fee income. And costs will have varying names; they are commonly referred to as expenses. 

Then it goes even further - everything is usually broken down into subcategories. For example, the follow categories could all be under the main category of Operating Costs: 

  • Cell phone;
  • Webhosting;
  • Internet.

Organization of a P+L Statement

Sales (which is sometimes also referred to as Income, Revenue and Fees) will typically be at the top of the P&L. Costs are broken down just below sales and the profit (or loss) is at the bottom. Depending on how your bookkeeper set up your accounting software, you may see a number of subtotals as you look down the column, but it is still sales minus costs equal profit.

Your company’s sales/revenue may be divided into several different sources. For example, an interior designer may have revenue from design fees for creating designs, revenue for receiving markup from furniture sales and revenue from hourly fees for project management. This business may choose to break sales into those three pieces so business owners can see what streams of income are the leaders so they know where to focus their efforts. Typically, these three components would be added together in a line called total revenue or sales.

Similarly, costs are usually broken into various categories. For example, you may see material costs, labor costs and overhead broken out separately. There are an infinite number of ways to break out costs and much of it will depend on the preference of an accountant or bookkeeper.

Breaking Down Costs  

One of the most useful ways to breakdown costs is into costs that are directly associated with delivering your product or service and those that are not. Costs that are directly associated with delivering your product or service are referred to as cost of goods sold, or COGS. Here's an example of cost of goods sold. The cost of purchasing chocolate for chocolatier who makes and sells chocolate would be a COGS. Another example of a COGS is the cost of lumber for a woodworker who makes custom furniture.

For a service business, this is called the cost of service (COS). For example, a professional organizer would include the cost of the employees who do the work, transportation cost and the cost of other supplies such as boxes and trash bags.

 

Gross Profit AKA Gross Margin

The equation for Gross Profit/Margin is as follows:

Sales - COGS = Gross Profit (AKA Gross Margin)

This is the money the business earns after it subtracts the cost of delivering its product and/or services. It is also the money needed to cover the other costs associated with running the business and still generate a profit.

Other Costs

There are tons of other costs a business can incur that are not associated with the direct production of a product or service. Some cost might include the cost of taking potential clients out to lunch to discuss a potential project, the cost of your public relations team and the cost of the bookkeepers run your bookkeeping software and generate your P+L reports. In the snoozefest that is the accounting world, these costs are commonly referred to as selling, general and administrative costs (SG&A).

With this addition, we can breakdown the P+L with the following equations:

sales - COGS = gross profit;

gross profit - SG&A = profit/loss

What's the story?

Beyond the numbers, your P+L statement tells a story. It is a representation of what your company has done over time. Reviewing your P+L each month, quarter and year is important for you to understand the cycles of your business. In other words, you can see what months and seasons your business is most or least profitable. You can see what lines of business are generating the most income and what lines of business are the costliest. From there you can begin to make business decisions that are based on all the information available to you.

Most of you didn't get into business because you enjoy reviewing your financials, but it comes with the territory. Learn to look beyond the numbers and tell your story through your financials. Do what you need to do in order to be an engaged business owner.

 

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