Q. I've started a small business and things seem to be going well. My accountant gives me P&Ls each month, but I don't really understand how to read them. Do you have any tips?
A. We can’t teach you to be a CPA, but we can give you some basics that will help you understand what your accountant is giving you.
All P&Ls are based on a very simple formula: sales minus costs equals profit. It really is that simple. Everything else is a matter of breaking out sales or cost into more detail and adding subtotals. Sales are typically shown at the top of the P&L. Costs are shown below sales and profit is at the bottom. You may see a number of subtotals as you look down the column, but it is still sales minus costs equal profit.
Unfortunately, we sometimes use different words for sales, costs and profits. This can make accounting seem more difficult than it really is. For example, sales can also be called revenue or income. Costs may be called expenses, and profits may be referred to as net income. In fact, the P&L itself (technically a profit and loss statement) can also be called an income statement. All of these AKAs can be confusing, but don’t let it throw you. A rose by any other name … our company’s sales may be broken into several different sources. For example, the sales of a restaurant may come from customers who dine in, customers who carry out and from catering. Such a business may choose to break sales into those three pieces. Typically, these three components would be added together in a line called total sales.
Similarly, costs are usually broken into various components. 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, but once you get below the total sales line everything else you see is a cost, broken out in one way or another.
One of the most useful ways to subdivide costs is into those costs that are directly associated with delivering your product or service and those that are not. Consider a company that makes and sells different types of widgets. It will have the cost of the components used to make the widgets, the cost of the workers who assemble the widgets, 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 widgets.
In a service business, this is called the cost of service (COS). For example, a lawn maintenance service would include the cost of the employees who do the work, fuel costs, and the cost of other supplies such as fertilizer and grass seed in its cost of service.
Sales minus COGS is known as gross profit (or Gross Margin). This is the money the business earns after 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 of the business are not associated with the production of widgets. Such costs might be the cost of the people who sell the widgets, the cost of the accountants who produce the P&Ls and even the president’s compensation. These costs are often referred to as selling, general and administrative costs (S,G&A). With this addition, the P&L is now broken down into two parts Sales minus COGS equals gross profit, and gross profit minus S,G&A equals profit.
Understanding P&Ls is essential to successfully running your business. The tips above will help.