Understanding Profit and Loss Statements
Originally published: 04.01.11 by Ruth King
The formula is simple, but listing items in the right categoriesand being consistent are vital.
Income statements are also called profit-and-loss statements. Most accountants call them P&Ls. People with finance backgrounds— like me — usually call them incomestatements. An income statement is a picture of the profit and loss of your company over a period of time. Unlike the balance sheet, which is a snapshot of the health of your business at that moment, an income statement looks at how the company has performed over a period of time. At the end of that period of tie, usually one year, the income statement “starts over.” One of the most common misconceptions about a P&L is that the net profit is cash. A positive number at the bottom of the P&L is profit. A negative number at the bottom of the P&L is loss. It is NOT how much cash you have. Most accounting programs provide for options with respect to the company’s income statements. Generally, owners choose to see month-to-date and year-to-date. Other options are month to-date this year, and month-to-date last year; as well as year-to-date this year, and year-to-date last year. I like to see where a company is month-to-date this year, and year-to-date this year; and compare it with last year’s monthly and yearly numbers. This lets owners know how they are doing for the year as well as how the current year compares with last year. Hopefully, the company is performing better than last year. If not, we need to find out why not. If the business performed well last year, figure out what went right, repeat it, and do it better in the upcoming year. If the business performed poorly, figure out what went wrong, fix it, and perform better in the upcoming year. The slate is erased at the end of each fiscal year! Many companies departmentalize their income statements. This means that the service department has its own P&L statement, the new-construction department has its own P&L statement,etc. A benefit of this method is that an owner can truly tell which segments of his business are profitable.Let’s take a look at some of the categories in the income/P&L statement formula:
There are different categories of sales. Some include new construction, service,replacement, remodel, service contract, warranty, and parts. Some contractors break sales into residential and commercial sales. Others divide them by the type of work, i.e., plumbing, electrical, hvac, boiler, oil heat, indoor air quality, or pool. There are numerous methods to departmentalize (break apart) overhead.The important thing is to ensure that each department gets its own income statement and stands alone; with a fair share of overhead. Each department should be profitable. If it isn’t, fix it or eliminate that department!
Cost of goods sold (COGS)or direct cost
These are expenses that are incurred because something was sold. Almost every contractor includes direct materials, direct labor, subcontracts, commissions,warranty, permits, and freight in cost of sales.There are also some gray areas. For example, some contractors include labor burden and truck costs in COGS. Their reasoning is there is a burden associated with each hour of direct labor (i.e., FICA and Medicare, unemployment taxes,health insurance, worker’s compensation)even when the employee doesn’t give an hour of labor. With respect to truck costs, the thinking is, “If I didn’t have a service call, I wouldn’t have truck cost. Each service technician has a truck and without a truck the service technician can’t do his job.” Some contractors say no, truck costs go in overhead. There is no right and wrong answer. Put these expenses where you are comfortable with putting them. The thing is that you have to be consistent. That means, if in one month you put labor burden in direct cost, the next month you can’t put it in overhead cost. So it’s got to be in cost of goods sold all the time or in overhead all of the time.
Gross profit is the result of subtracting cost of goods sold or direct expenses from sales. Another term you’ll often hear is gross margin (GM). Gross margins defined as gross profit divided by sales. Gross margin is always a percentage. Gross profit is always dollars. To get operating profit, subtract overhead from gross profit.
Overhead is the expenses that the business incurs so that it can stay in business. Generally it is divided into two pieces, compensation expenses and general and administrative (G&A) expenses. G&A expenses are also called operational expenses. Compensation expenses are salary-related expenses. They include office salaries, unapplied time, owner salaries, and labor burden if labor burden is included here rather than in direct expenses. In either case, your compensation expenses will have the labor burden for the office staff and owner’s salaries. It is important to understand that unapplied time is an overhead expense.This is time that the company chooses to pay its field labor for hours that it is not producing revenues for the company. For example, if a plumber goes out on a service call that is a direct cost and is included in cost of goods sold. If the plumber is attending a meeting or a training class, that’s unapplied time, which is accounted for in overhead compensation expenses. Unapplied time can be very valuable for that plumber. However, that time is not generating revenues for the company. Callbacks are also unapplied labor. They usually have their own category in compensation overhead.The only costs that go into direct costs are those costs that are incurred when a field employee generates revenues or sales for the company. Meeting time, training time, travel time, anything that is not generating revenues but is paid for goes into unapplied time in compensation overhead. One contractor asked me why I choose to break out compensation overhead from G&A overhead. From my perspective, the area contractors have the least control over is labor. I want to see what the expenses are each month, both in direct labor and in overhead labor. A contractor has to watch labor very closely. The best way I know how to do that is to put it in its own special category in overhead. This way every month, when the owners review the financial statements, they can see how much was spent on overhead labor, callbacks, and unapplied time. If it is out of line, the owners can do something immediately.Here’s a real life example: I worked with a contractor a few years ago whodidn’t believe he had an unapplied time problem. I realized that the only part of his income statement he really looked at was the net profit before taxes. The reality I found was that the field labor were putting 40 hours on their time sheets but only producing revenues for 25 to 30 hours per week. So, I asked the bookkeeper to change the place where the unapplied time and callbacks were printed on the income statement . . . right before total expenses and operating profit. The owner saw these numbers every month. Very soon unapplied time and callbacks decreased dramatically, which increased the profitability of the company. So, if you think there is an issue with either direct or indirect expenses, you can change the income statement format. Remember it’s your income statement. You can look at it in ways thatyou’d like to look at it — not necessarily any standard way that an accountant wants you to look at it. The next segment of the income statement is G&A overhead. These expenses include rent, utilities, dues and subscriptions, accounting fees, bank charges, donations, telephone, insurance,travel, entertainment, and many other expenses the business incurs which are not a result of selling something. If truck costs are not included in direct labor, they go here. Operational overhead expenses are the expenses that don’t change radically on a month-by-month basis. The changes normally are due to increases or decreases in truck costs. Look at this section of the income statement for consistency. For example, if the company’s rent is $1,000 a month, and there is a rent expense in January and not one in February, find out what is going on. You know something is wrong because your landlord is not going to let you get away with not paying your rent in February. Likewise, watch insurance expenses. If the insurance payments are due once per year, the month they are due should not show the entire insurance expense.The insurance expense is an asset, a prepaid expense. Each month one-twelfth of the payment is considered an expense to the business.
Net Operating Profits
Overhead expenses are subtracted from gross profit to arrive at net operating profit. This is the “ordinary profit,” the profits that are generated from regular sales and expenses that occur on a day-to-day basis. However, sometimes there is income or expense that is not generated from day-to-day operations. This gets added or subtracted next. What are some things that are other income or other expenses? Other income is usually interest received from investments or gain on sales of assets. If the company sells a truck it mighthave a gain on the sale of that truck. It happens when on the balance sheet, the value of the truck is $1,000, and the company sells it for $2,000. The extra $1,000 is other income to the company. . . and yes, you have to pay taxes on that income .Other expenses are usually losses on sales of assets. If, the company sells that truck for $500, and its value on the balance sheet is $1,000, the company has a loss of $500, which it can take away from profits. Inventory is a special case. If, at the end of the year, the balance sheet says the company has $100,000 in inventory and when it is counted, the value is $90,000,the company has a $10,000 loss. That $10,000 goes against net operating profit. This can be a nasty surprise when the owners think that the company is earning a good profit and the inventory is vastly different from what the balance sheet says it should be.The other case doesn’t happen much, but I have seen it. If, at the end of the year, the balance sheet says the company has $100,000 in inventory and when it is counted, the value is $110,000, the company has a $10,000 profit. That$10,000 is added to net operating profit,and you pay taxes on the additional $10,000. The company might also have discounts that it has taken if a supplier offers a discount for early payment. That discount goes in other income.
Net profit before taxes and netincome
After adding other income and subtracting other expenses, the company has net profit before taxes. Then income taxes are subtracted to arrive at net income.This is the figure that is added to retained earnings on the balance sheet.The income statement formula is straightforward. It is sales minus cost of goods sold equals gross profit. Subtract overhead from gross profit to arrive at net operating profit. Then add other income or subtract other expenses, and the result is net profit before taxes. Subtract out income taxes and the bottom line,net profit, is shown.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and to become more profitable. She is president of HVAC Channel TV and holds aClass ll (unrestricted) contractors license inGeorgia. Ruth has authored two books:The Ugly Truth about Small Business andThe Ugly Truth about Managing People.Contact Ruth at www.hvacchannel.comor 770-729-0258.