Updated: Jan 4, 2020
How many entrepreneurs start organizations because they are passionate about the primary operations of their business -- not accounting. For the most part, entrepreneurs aren’t comfortable interpreting the monthly financial reports they receive. Do you feel this way?
Seventy five percent of business owners can't accurately read and understand a Profit and Loss Report. While we can’t teach you to be a CPA, we can give you some basics that will help you understand and be able to make sound decisions for your business based on your financial reports.
Profit and Loss Reports have a simple formula
All Profit and Loss Reports are based on a very simple formula -- income minus costs equals profit. Everything else is a matter of breaking out income or cost into more detail and adding subtotals. It really is that simple.
Income - Costs = Gross Profit
Income is typically shown at the top of the Profit and Loss Report. Costs (COGS) are shown below income and gross profit below these. 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 income may be broken into several different types or subcategories. Your Profit and Loss report can be very simple or as detailed as you wish.
Related: How to Read a Balance Sheet
Understanding Cost of Goods Sold
One of the most useful ways to subdivide costs is into those costs that are directly connected with delivering your product or service. For example: consider a company that makes and sells protein powder. It will have the cost of the ingredients used to make the protein powder, the cost of the workers who assemble the product and the costs of the production facility. These costs are referred to as cost of goods sold (COGS) because they can be tied directly to the production of your product.
Understanding Cost of Service
In a service business, this is called the cost of service (COS). For example, a pool cleaning service would include the cost of the employees who do the work, fuel costs and the cost of other supplies such as chlorine and repair parts.
Expenses that are not considered Cost of Goods or Cost of Service
There are other costs of the business that are not related with the production of protein powder. Such costs of office staff and admin personnel, the cost of the accountants who produce the P&Ls and even the president’s salary. These costs are most often referred to as general and administrative costs (Operational Expenses).
Income - COGS = Gross Profit and Gross Profit - Operational Expenses = Profit
With this addition, the P&L is now broken down into two parts: sales minus COGS equals gross profit, and gross profit minus SG&A equals profit.
Spend a few minutes each month reviewing your Profit and Loss Report for accuracy and customize your report so you can see the comparison from the prior month, year or period.