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Each component influences the determination of net profit, and are used in the two basic equations.
A profit and loss statement is based on two basic equations:
Gross profit and net profit is calculated as follows:
| Revenue | $ 550,000 | |
| less | Cost of good sold (COGS) | $ 220,000 |
| Gross Profit | $ 330,000 | |
| less | Expenses | $ 275,000 |
| Net Profit (before tax) | $ 55,000 |
The main components of a profit and loss statement are:
Revenue (sales) is the total earned from ordinary business operations. Revenue includes sales of goods and services, interest received, dividends, rebates, and rent received.
Cost of goods sold (cost of sales) is the cost of merchandise sold during the period. COGS includes all the costs directly related to getting your inventory ready for sale such as:
COGS vary directly with sales and production; the more items you sell or make, the more stock or components you need to buy. Generally, COGS only applies where there is a sale of stock or inventory and is the total direct cost of getting your products into inventory and ready for sale.
Items included in the COGS will differ from one type of business to another.
Retail business:
Manufacturer:
Business selling only services (e.g. accountants or consultants):
For example, the COGS for a bicycle retailer would include the costs of the component parts plus the labour costs used to assemble the bicycle.
COST OF GOODS SOLD IS CALCULATED AS FOLLOWS:
| Opening inventory (cost of inventory at the beginning of the period) |
$ 10,000 | |
| plus | Inventory purchased (during the period) | $ 43,500 |
| Equals | Total inventory available during the period | $ 53,500 |
| less | Closing inventory (cost of all unsold stock) | $ 7,000 |
| Cost of goods sold | $ 46,500 |
Gross profit is the difference between sales and the cost of producing or purchasing products or providing services before subtracting operating expenses such as wages, rent, accounting fees, or electricity. Gross profit reflects how efficiently labour and materials are used to produce goods.
Gross profit = sales – cost of goods sold
The gross profit margin is one indicator of the financial health of a business. Larger gross profit margins are better for business – the higher the percentage, the more the business retains of each dollar of sales for other expenses and net profit.
Gross Profit Margin % = (Gross Profit ÷ Sales) x 100
Expenses (overheads, outgoings) are costs incurred for the purposes of earning income. They include items such as:
Net Profit (net income; net earning; the bottom line) is calculated by subtracting expenses from the gross profit, showing what the business has earned (or lost) in a given period of time (usually monthly, quarterly, or annually) after both the cost of goods sold and operating expenses have been taken into account.
Net Profit = Gross Profit – Expenses
For sole traders, drawings are not an expense and net profit is calculated before the owner’s benefits are subtracted, and is the total taxable income of the business. You pay tax on the entire net profit, regardless of how much you have taken out for your drawings.
For partners where no partnership agreement exists, net profit is allocated according to the proportion specified in the partnership agreement. Each partner pays tax on the proportion of their interest of the total net profit, regardless of how much the partner takes out as drawings.
For companies, salaries for working directors are treated as an expense along with other employees’ wages. So, net profit is what’s left after these salaries have been subtracted, and it is then available for distribution to shareholders as dividends.
For a service business, net profit will be the difference between the income of the business and its expenses, given there is no gross profit calculation.
Refer to the example profit and loss statement.