Three Levels of Profit - Know Your Profit & Loss Statement
To get the most out of your Profit & Loss report, it is important to set-up the chart of accounts and layout of the report in your accounting software. Let's take a deeper dive at this important report and show why it is worth the time and effort.
Sections of the Profit & Loss report
Cost of Goods/Sales
Other Income & Expenses
Let’s focus on “Cost of Goods Sold”. If you don't sell products, or provide a mix of products and services, you probably are not using this part of the Profit & Loss statement. The “Cost of Goods Sold” section should really be called “Direct Costs”. These costs are directly related to sales. Identify which costs rise when a sale is made. These are your direct costs. These direct costs are included in calculating your “Gross Profit”, but more on that later.
What about costs that could be both?
Paying staff, office supplies, rent, and vehicle expenses are examples of expenses that could be directly related to sales and administration. Obviously, at the end of the day, all the expenses are related to sales, or the business would not exist. A common issue that arises is what gets included in Direct Costs. The key to categorizing expenses that could be split between Direct Costs and Operating expenses is consistency. When creating financial ratios, it is critical to use the same calculations every month. Consult with your accountant, and decide where to place these expenses on the Profit & Loss statement. Allocating a percentage of expenses to direct costs is also an option, assuming the allocation will be made whenever the PL report is generated.
Other Income & Expenses
Businesses usually post income and expenses outside the scope of normal business operations to “Other Income & Expenses”. Credit card cash back, insurance proceeds and penalties and fines are a few examples. Your business may not have these, but they do exist, and it is important to categorize them correctly.
Three Levels of Profit - Gross Profit | Operating Profit | Net Profit
Gross Profit Margin = Gross Revenue - COGS/Revenue
This is a big one to know. Remember above when we identified direct costs? Knowing your Gross Profit Margin is critical to understanding the profitability of your business. This ratio should be calculated on a monthly basis, at a minimum.
Operating Profit Margin - Operating Revenue/Revenue
Operating Costs, sometimes referred to as overhead, include the expenses further down on the Profit & Loss statement. These would include office supplies, rent, staff payroll, interest paid, and accounting fees, among other expenses.
Net Profit Margin - Revenue - Cost/Revenue
For many businesses, the Net Profit Margin and Operating Profit Margin are often the same. If no activity is posted to “Other Income/Expense for the given time period, the two ratios will be the same.
Setting up your Profit & Loss report will not only be easier to read, it allows calculating the above ratios quicker anytime you run the report. Working with an accountant who offers CFO services can help your small business set-up your reports.
James Fleming III, EA
Sentinel Tax & Accounting