PROFIT AND LOSS STATEMENT
If you are running or about to start your own business, you have probably come to realize the significance of making a profit. This is obviously the ultimate goal for running your business. Although this may be obvious, what’s not always obvious is how to go about analyzing what your business is doing from a profit standpoint. Not everyone is accounting savvy, but there is a tool that is universal in determining profit levels for your business. This is known in the financial community as a “Profit and Loss Statement”. We will refer to it as a P&L. This statement can take on many variations depending on the specifics of the company (profit vs non-profit, sole proprietor vs. corporation etc…), but they will all end up doing basically the same thing which is analyzing your Sales or Revenue as it compares to your expenses on a monthly basis.
Here is the formula; Sale – Expenses = PROFIT. Monthly analysis can be compiled quarterly and yearly to give you a good indicator as to how your company is performing. Determining your Sales is the easy part. That is simply the amount of money you billed to a customer for the month that eventually becomes revenue. Listing the expenses is where it can become a bit more challenging. Let’s start by distinguishing the two different types of expenses as they relate to the P&L. They are Direct Cost and Indirect Cost.
Direct Cost
Direct cost is the easier of the two to determine. Direct costs are those costs that are directly related to generating that revenue. Examples of direct cost would be the labor you pay to employees doing the work, the materials bought to build the widget that you sold, or the shipping costs that were expended to get the finished product to the customer. These are all examples of direct cost. Cost directly related to making that sale and generating that revenue.
Indirect Cost
So what exactly are indirect costs? These cost you would probably not even consider as you look at what you had to spend to get to your revenue. So, for discussion sake, let’s say you know that you paid your employee’s for their labor involved with generating the Sales for that month (your direct cost). But you also paid these employees group insurance for the month and you paid the rent for the office space they occupy to perform the work.
You know you paid the vendor for the materials you used to make the widgets (your direct cost), but you also paid the phone bill which provided the services that allowed you to call and place the order, as well as office supplies you used to write up the order after the call for your tracking purposes. These costs, although not directly involved with generating your revenue, still add cost for the month that impacts your profit. I can’t stress enough how important it is to capture all cost involved. That is the only way you can determine your true profit.
So how do we show these costs as we list our expenses to arrive at our profit? Direct costs are easy. We will just list all labor, materials and anything obtained that was directly involved with generating that revenue. However, for indirect costs, they are presented a little differently. The two most used and recognized indirect costs are, “Overhead Costs” and “General and Administrative Costs”. We will refer to them as OH and G&A respectively moving forward. OH costs are those costs associated with things like Employee group insurance, Office Rent, and Employee parking at the job site, just to name a few. They are costs that you pay out as a company each month, but are not directly tied to your specific sales for that month.
General and Administrative costs are usually smaller costs and more likely associated with the day to day expenses with running an office. They could include things like office supplies, coffee and water for the office kitchen, cleaning supplies for the office, etc. Since these costs occur monthly and are for a variety of different things, it would be very difficult to try to list them as individual cost elements as you determine your profitability. For this reason, indirect costs are presented on the P&L in the form of a percentage (%) that gets applied to your direct cost elements. The Overhead costs will be applied against the employee labor you pay monthly, and the General and Administrative (G&A) costs will be applied against all other cost including your OH. Let’s take a look at this example.
Labor cost for the month: $2,500
Overhead rate= 25%
Overhead cost = $625
Total Labor and O/H = $3,125
Total cost for the month: $5,000
G&A rate= %5
G&A cost = $250
Total Cost and G&A = $5,250
Note that the indirect costs are absorbed into the total costs in the form a percentage rate. This allows you to capture these costs based on your level of direct cost spent. It will help you in determining your profit by accounting for all costs involved with generating that revenue.
You may ask, so how do I know what my OH and G&A percentage rates should be??? That is a great question. It is one that depends on all the different and unique factors that make up your particular business. If possible, I would strongly suggest that you consult with a professional when determining these rates. If you are just starting or can’t afford a professional, not to worry, there are businesses that don’t have a clue about indirect cost and chug right along simply comparing their sales against direct cost. They fail to realize that they are not capturing their true profit. Sole proprietor type businesses just starting out, many times are not even aware of indirect costs until they get to the point in their business where they hire professionals. Even if you understand the concept and realize that it is necessary to get to your true profit, that gives you at least somewhat of an advantage. So here is a quick example of how you may go about determining what rates you could use. There is no black and white to this, and it really does depend on various aspects of your company, but this will give you an idea of what is involved in the process.
OH rates should be a percentage of your labor costs and should be applied monthly throughout the year. If you are a brand new company and don’t have a labor history to draw from, you can project what you anticipate the amount of labor costs you will spend for that year. Once you determine that, we can start figuring what OH costs should be applied to the labor. See below:
Base Labor Cost for 2014 = $95,000
OH Elements to apply are based on annual costs:
Group insurance costs = $2,500 = 3% of base labor
Employee parking cost = $1,000 = 1% of base labor
Paid Holiday costs = $2,000 = 2% of base labor
Office Space = $18,000 = 19% of base labor
If you add all your percentages together, you will come up with an OH rate of 25%. This will be the rate you can use against all future direct labor costs for that year, which gets you closer to realizing your true profit.
G&A rates are not quite as involved. That is usually a very small percentage. You can take what you spent on office supplies, cleaning supplies, coffee and water for the kitchen or any office related costs you can think of. This percentage rate will be applied against all costs. So you can take a look at your total costs for the year, and list the G&A costs for the year to calculate your rate. See below:
Total Cost for 2014 = $205,000
G&A Elements to apply are based on annual costs
Office supplies = $6,200 = 3% of total costs
Cleaning supplies = $2,000 = 1% of total costs
Kitchen supplies = $2,000 = 1% of total costs
If you add all your percentages together, you will come up with a G&A rate of 5%. This will be the rate you can use against all costs including labor and OH which can be applied monthly to your costs.
So hopefully we all feel a little more comfortable with our understanding of profit and the different cost elements that can impact it. Using indirect cost as a part of your analysis gives a better depiction of what the true costs actually are. Now you are equipped to determine your true profit. Good Luck!!!!
By: Johnny Lewis
