Basics of Profit and Loss Account
What is a profit and loss statement?
A profit and loss (p&l) statement is usually presented as a report and shows the business activity and related expenses of an organization over a period of time.
A typical p&l will contain the following:
This is the turnover of the business, the main source of income from sales of products or services. This figure is always exclusive of taxes, as they are paid to the government and do not form part of the business’s income.
Purchases are the goods you buy to sell to customers. A basic accounting principle is that income is accurately matched with the costs of generating that income. In this regard, the stock or inventory on hand at the end of the accounting period is always deducted from the total cost of purchase. These inventories will be used to generate future sales and will be matched against these sales in the next period.
Costs related to sales
These costs are those incurred directly in the process of selling to a customer. These include items such as sales commission, promotional costs and courier charges.
Finally, there are business overheads. These are the costs incurred by the rest of the business that are not directly related to the sales process. Examples of overhead costs are: administrative staff salaries, lighting and heating, office supplies, computer maintenance, and legal and accounting fees.
Two versions of the income statement
In published accounts, the P&L account has a standard format, this is to aid understanding and interpretation of the information. The accounts are commonly known as financial (or statutory) accounts and are subject to accounting and legal management principles.
However, to really understand how your business is performing, you need to prepare a fully detailed income and loss account, this is an extended version of the published accounts and usually has additional information such as ratio analysis and key performance indicators.
This version is usually called “management accounts” simply because they are figures intended for management and not for external publication. Therefore, there are no regulatory guidelines for their composition to worry about.
Management accounts are the tool you need to have to see if your business is profitable and are usually prepared regularly, usually monthly, for each of your product lines. The P&l is a central part of the management accounts suite.
Regular review is necessary because you need to be aware of areas that are not meeting targets as soon as possible; so that you give yourself time to take corrective action before the end of your financial year. For example, if a regular customer has started placing orders haphazardly, it may turn out that upon investigation you will find that he is testing one of your competitors. This gives you the opportunity to run some special promotions or renegotiate the deal with your customer to win your business back from your competitor.
You will also find that budgeting is a valuable tool for your business. The budget is a financial plan for the coming year. Creating a budget allows you to review all areas of your business to ensure that they are justified and that you are getting the most out of your assets or resources.
Throughout the year, you compare your actual results to your budget and examine where results fell short of plan. Examples of problems could be cost overruns due to inefficient stacking or unnecessary use of more expensive components. Again, this review process gives you time to make changes before problem areas get out of control.
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