Components of a Profit and Loss Statement

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 = sales – cost of goods sold
  • Net profit = gross profit – expenses

 

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

Revenue (sales) is the total earned from ordinary business operations. Revenue includes sales of goods and services, interest received, dividends, rebates, and rent received.

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Cost of goods sold (COGS)

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:

  • the purchase price,
  • import duties,
  • non-recoverable taxes,
  • freight inwards,
  • freight insurance,
  • handling,
  • direct labour, and
  • other costs of converting materials into finished goods.

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:

  • COGS includes the cost of buying stock for resale, and freight inwards.

Manufacturer:

  • COGS includes the cost of raw materials or parts, and the direct labour costs used to manufacture the product.

Business selling only services (e.g. accountants or consultants):

  • These usually do not have COGS unless they hire additional casual or contract labour to provide direct services to clients.

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

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Gross profit

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

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Expenses

Expenses (overheads, outgoings) are costs incurred for the purposes of earning income. They include items such as:

  • wages,
  • rent,
  • accounting and legal fees,
  • electricity, depreciation, and
  • interest paid on loans.

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Net profit

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

Sole traders

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.

Partners

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.

Companies

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.

Service businesses

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.

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