Profit and Loss 101
What is the P&L?
When we refer to financial statements, we generally mean:
- The Balance Sheet
- The Income Statement, also known as the Profit and Loss or P&L Statement
- The Cash Flow Statement
The Balance Sheet shows balances as of a specific date. It is a snapshot of the organization’s financial position. The P&L shows the net of increases and decreases over a period of time. It is a video of the organization’s financial transactions. The Cash Flow Statement focuses on only those accounts/transactions that affect cash. For example, payment to buy a new computer affects cash; depreciation of the computer over three years of useful life, does not.
Note that P&L, Profit and Loss, or Income Statement all refer to the same financial statement; the labels are interchangeable. This statement is most often presented for one calendar month, but might be presented for a fiscal month (Some organizations use accounting periods that group whole weeks, instead of beginning or ending a month in the middle of a week.) or only every three-month calendar/fiscal quarter. For ease of explanation, our examples will use one calendar month.
The P&L is presented in three main categories of accounts. The first section of the statement shows gross Income. For example, the organization sells only one item (Widgets), always at the same price ($1,000), and sells 25 of them during June. Sales for June are $25,000. In this example, Income is also $25,000.
The second portion of the statement shows Cost of Goods Sold. “Goods” applies to both products and services. To decide whether a cost belongs here, ask the question: If not for this particular IT project – or, if not for this customer-ordered Widget – would the organization incur the cost? A “no” answer indicates that the cost is for a component of the product or service sold.
Cost of Goods Sold – Services
The accounts in this section of the P&L show direct costs of presenting a training seminar, updating an information systems network, or testing soil in preparation for construction. The labor to develop the outline, slides, and handouts; the training room rental; and the purchase of audio-visual equipment are costs of presenting a training seminar.
Often one person contributes direct and indirect labor. Actually providing services to the customer, such as standing before a group of people and presenting training, is direct. Coordinating the schedules of trainers and customer training sessions is indirect. Time for each dual contributor is recorded and tracked. The applicable portion of the cost of his/her labor is allocated to Cost of Goods Sold.
Cost of Goods Sold – Product Example
In our example, the raw materials to assemble a Widget cost $350 per finished product. Labor to assemble one Widget costs $370. There are no additional costs for (vendor) goods or (employee) services, which become part of the Widget. Cost of Goods Sold for June is (25 Widgets at $720 each) $18,000. (Services include contracted or outsourced services in the direct assembly/creation of a Widget.) The P&L shows gross profit or loss, which is Income minus Cost of Goods Sold. Gross profit for June is ($25,000 minus $18,000) $7,000.
For small businesses, indirect costs that do not logically fit into Overhead are usually included in G&A for simplicity. The total pool of G&A costs is allocated on one basis; it is one overall pool caused by or benefiting the entire company.
Those costs that cannot be reasonably attributed to a particular project, but relate to Direct Labor, are Labor Overhead (usually called Overhead). In small businesses, the project manager generally charges the project/job for time worked on the project. What about indirect costs related to services/labor of the project manager? Examples might be:
- Company-paid portion of health insurance
- Salary for time taking training related to the type of project (as opposed to, say, communication skills or time management)
- Paid Time Off
- Company cost of relocating a new hire
- Unemployment Compensation premiums
Note that, a case can be made for including any of these costs in G&A. For any one of the examples (or general ledger accounts), the costs related to all employees are treated the same. If company-paid Medicare and Social Security taxes (FICA) for the project manager are included in G&A, instead of in Overhead, then FICA for all employees is included in G&A. The defining question: Is the inclusion supportable?
The last portion of the statement describes Expenses. These are costs of running a business, and not directly allocated to the assembly or creation of a Widget. June Expenses are:
|Outsourced Human Resources||300|
|Part-time Receptionist (Wages)||800|
At the bottom of the P&L is the net profit or loss for the period. The net profit for June is (gross profit of $7,000 minus Expenses of $6,750) $250.
One percent (1%) of the price for each Widget sold is net profit. The other ninety-nine percent (99%) is spent on the creation of the Widget and running the business.
What Percentage is Good?
Any profit (as opposed to loss) percentage is good. Although each $1,000 (priced) Widget results in $10 of net profit during June – the more Widgets sold, the more profit for the month. The higher the percentage of net profit, compared to Income, the better. There are two major factors, which impact this percentage.
First, Cost of Goods Sold increases as the quantity sold increases. The factor, which can slow the increase (in Cost of Goods Sold compared to Income), is quantity discounts. For this discussion, we ignore lowering the quality of components (such as less talented trainers or cheaper raw materials). Scrap, obsolescence, and storage costs are not considered, here.
For raw material, suppliers sell at a high unit price for a small-quantity order. Suppliers usually offer lower unit prices at quantity breaks. For example, Gidgets might cost $20 each for an order of 25 or fewer – but cost $18 for an order of 26 to 50. If one Gidget is a component of each Widget, as the quantity of Widget sales increase above 25, the Cost of Goods Sold (for each Widget and for the month) increases at a lower rate.
25 Widget Sales require 25 Gidgets at $20 each, for a total of $500. The original June Income is $25,000.
50 Widget Sales require 50 Gidgets at $18 each, for a total of $900. 200% of the original Income increases to $50,000. The cost of Gidgets increases (900 divided by 500) only 180%. The Cost of Goods Sold savings is $2 per unit.
Second, the Expenses increase as the quantity sold increases. The factor, which can slow the increase (in Expenses compared to Income), is fixed costs. Many Expenses remain fixed, regardless of the quantity of units sold. For example, building rent does not change until the quantity sold requires a second (or larger) building. Salaries for administrative functions do not increase and decrease with short-term changes in sales volume. Because Expenses are stable over a wide range of sales volume, this section of the P&L warrants an eye toward cost-cutting.
What Costs Warrant Review?
Any cost that cannot be reasonably attributed to a particular service or product is an Expense. The ultimate question is, “If not for this product (or service), would the company incur this cost?” If not, then the cost is a Cost of Goods Sold. If the answer is, “Yes,” then the cost is an Expense.
General & Administrative, or G&A, costs are those relating to the company as a whole. These can encompass facilities, administration, and general costs. Facilities costs include:
- Rent or mortgage
- Electric and ga,
- Cleaning and plant watering
- Routine building maintenance
Administration costs include:
- Company-wide accounting and budgeting
- Administering employee benefits, employee reviews, and related human resource activity
- Meetings of the owners or board of directors
Examples of general costs include:
- Company party to celebrate holidays
- All-hands staff meetings
- Employee training on Communication Skills
Indirect costs that do not logically fit into Overhead are usually included in G&A for simplicity. Total G&A costs, caused by or benefiting the entire company, are Expenses. Larger companies sometimes maintain more rates – and dollars allocated to specific sales contracts. Although not required, Facilities might have one rate for the office at Location A and a different rate for the office at Location B; separating the rates more precisely allocates dollars, for example, to a customer Job performed only at Location B – especially if Location B is a small, rural office with disproportionately lower expenses. One size does not fit all organizations; the indirect rate structure (i.e., the number and type of rates) is unique to each company.
Overhead or burden is a label often applied to all Expenses. Specifically, Overhead are those costs that cannot be reasonably attributed to a particular product or service and are not G&A. What about compensation beyond wages and salaries? These indirect costs related to the direct labor are Labor Overhead. Examples might be:
- Company-paid portion of health insurance
- Wages for time attending self-improvement training
- Paid Time Off
- Unemployment Compensation premiums
Manufacturers, assemblers, and other product-providers might have Material Overhead, which are also Expenses. Examples might be:
- Shop rags
- Oil and other machinery lubricants
- Low-cost, common items(e.g., solder, saw-dust filters, brooms)
Because laws (and the competitive market for labor) often dictate the highest Overhead costs (or the Fringe Benefits portion), cost controls are generally focused on G&A.
How Much Expense is Good? P&L Comparative Analysis
Comparison of one specific company to another is, usually, misleading. Companies in a growth spurt incur higher marketing costs than stable firms do. Also, growth spurts results in a lag; expenses for newly hired administrative staff (plus computers, furniture, and bottled water related to them) increase before Income from higher sales is received.
Different markets or industries show very different Expenses and net profit percentages. Comparisons among organizations are best limited to the same market and the same size and age (or place in the growth cycle). Publicly held companies publish financial data, which can be used as a guide; small, privately held businesses experience more difficulty obtaining comparative data.
Most important, frequent comparisons from one time period to another, for your own company, are analyzed. Do not stop with the net profit percentage for last year compared to this year. The P&L provides vital data for anticipating trends and analyzing future concerns by account. Trends compare each of several consecutive months.
Moving, weighted averages are recommended to project future trends. For simplicity, we can calculate a trend just using totals from the P&L for each month from January through June, inclusive. The following information shows how trend analysis is accomplished, and what it tells us.
|MONTH||INCOME||NET PROFIT||NET PROFIT PERCENTAGE|
|March||$19,000||– 0 –||0%|
The Net Profit Percentage increased, from month to month, as shown:
|January to February||1%|
|February to March||1%|
|March to April||.5%|
|April to May||.3%|
|May to June||.2%|
These comparisons indicate that the Cost of Goods Sold and (more likely) Expenses are increasing at a faster rate than Income (or Sales).
This unfavorable trend initiates a careful comparison, first, of each Expense shown on the P&L, from one month to the next. We can begin with the average increase (from January to June) by account; however, comparing changes from one month to the next yields more revealing information. For example, the President’s salary might be tied to sales for the month – or for the previous month. Information Systems and Outsourced Human Resources increase during growth; if these two Expenses show the largest impact, their increases might indicate a positive reason for negative changes in the Net Profit Percentage.
What Other Considerations Impact Analyses?
Like no man, no P&L is an island. Analysis in a vacuum leaves a huge gap in the company’s financial story. Many of the most revealing ratios, or financial comparisons, use more than one financial statement. For example, material in the Cost of Goods Sold portion of the P&L for the month of June, divided by the inventory on the June 30 Balance Sheet, tells us how many times (during June) the “entire” inventory was replenished. $350 of material times 25 Widgets sold equals $8,750. If (Balance Sheet) inventory is $4,375, then inventory turns over (or is replenished) twice per month. The inventory must be available (per the snapshot) before it can become a Cost of Goods Sold.
Generally Accepted Accounting Principles (usually) require the use of accrual basis financial statements. Many privately held companies use cash basis. Accruals, accurate cut-offs, and related issues affect P&L analysis. Comparisons of one financial statement to another must use consistent bases to render meaningful conclusions. Also, cash basis financial statements rule out many important ratios; for example, the percentage of customer receivables that will be written off as uncollectible is not recognized in advance.
The P&L discloses much vital information about Income, Cost of Goods Sold (whether products or services), and Expenses. The consideration that most affects analyses, is the amount of time and effort invested by the analyst. Comparing the Net Profit Percentage increases (above), as they dwindled from month to month, triggers further examination. A ratio of each Expense to Income, from month to month, highlights a (disproportionately) rising Expense. Review of the individual transactions in this specific Expense account reveals anomalies and/or unusual quantities. The further the analyst digs, the more enlightening are the results.
A basic understanding of the relationship among Income, Cost of Goods Sold, and Expenses is a great start!