Profit and Loss statement

Profit and loss statement shows business gains or losses at the end of the fiscal year. It shows the degree of coverage of costs and the amount of profit made in the end. Profit and loss account can be prepared using two methods: direct and indirect method. The difference between the two methods result in a completely different figures of loss or profit from the other, and the reason lies in their approach to assigning costs to the product. The profit and loss statement is created annually, however it can be measured in shorter periods (quarterly or monthly) as well.

Sales revenue

In order to determine the annual profit or loss, we need the amount of sales revenue, which is shown with ‘S’. This figure can be obtained by multiplying the average price per unit of product (R¹) to the quantity of the goods sold (Q). Therefore: S=R*Q. The next step is the deduction of costs to determine the final profit/loss figure.

Note: The average price per unit indicated using ‘R’ is different from another figure shown as ‘r’ which indicates the average variable cost of goods sold. The average variable cost per unit is obtained by diving variable costs to the number of units: r=VC/Q.

Indirect method

In the indirect or traditional method, total Cost of Goods Sold (COGS) including both fixed and variable costs are deducted from revenues, leading to the gross profit. Gross profit less administrative and sales/marketing costs shows the operating profit. The operating profit indicates earnings made from the normal activities of the business rather than other methods of earning such as financial investments. The next step is to deduct financial expenses (interest) from the operating profit. Financial expenses are loan interests paid by the company. At this point, we have reached the company’s profit before tax.

Note that this method reduces all costs from the revenue, even fixed costs which are not directing related to the production process. It assigns costs to the revenue which increases the cost of goods and decreases the profit. The direct method, however, offers another approach that leads to a different number. Read below to learn more about fixed and variable costs and their use in the direct method.

Direct method

In the direct method, costs are divided into fixed and variable ones. Before we move on to the direct method, it is essential to know about fixed and variable costs. In general, fixed costs refer to those which are constant to the business regardless of the manufacturing or service providing process. These are the essential requirements to run a business. For example, an office building or cars that are used for transportation produce expenses that exist regardless of production. Contrary to fixed costs, variable ones refer to those that have to be paid in order to manufacture goods or provide services.

Fixed Costs

Fixed costs are constant business expenses. They include overheads such as Fixed Financial Costs (FFC), Administrative Fixed Costs (AFC), and Overhead Factory fixed Costs (OFC). On the other hand, variable costs are those which are directly related to the production or service providing process. Based on this definition, only variable costs of producing goods sold are subtracted from sales revenue to arrive at the Contribution Margin (CM).

Variable Costs

 Variable costs is calculated using the average variable costs per unit (‘r’) and the quantity of the goods sold: VC=r*Q. Other variable costs can be included if costs are analyzed and divided into fixed and variable ones, which in some cases may be difficult or take a long time to determine. For example if it has been determined that notable electricity costs exist due to manufacturing processes, they have to be considered as variable costs. This leaves us with the contribution margin (CM).

From revenues to Earnings Before Interest and Tax (EBIT)

 Contribution margin is the selling price per unit minus variable costs per unit (R-r). It represents the amount of revenue not consumed by variable costs which, therefore, can be used to pay fixed costs. Subsequently, overhead costs are removed from the contribution margin, resulting in a figure showing Earnings Before Interest and Tax (EBIT). Then, after the deduction of interest, we arrive at the gross profit. Gross profit minus tax payable leads to the net profit of the business. In case the company has preferred stocks, related earning payments take precedence over common stock. Therefore, net profit is reached after preferred stock earnings are also deducted.

Note: In some cases, such as projects which involve several years of construction, the company faces only loss due to regular expenses and no income. However, after the completion of the project, it begins producing goods or providing services that yields profit. This is a gradual event and expectations of large amounts of profit is not reasonable. In contrast, meeting reasonable expectations are business responsibilities.

    Profit and loss statements indicate the financial condition of a business. Yielding healthy profits not only satisfies shareholders, but attracts other investors that a business needs in order to grow. Therefore, having consistent profit yielding years add to the credibility of a business. Naturally constant shifts between profit and loss indicates problems that may lead to loss of trust from shareholders and eventually loss of potential investors.