BUSINESS Demystifying Your Income Statement INCOME STATEMENT OF XYZ COMPANY INCOME: Gross Sales Net Sales For the period XXX (Typically for one month. Issued for each month of the year) (Overarching category of all money that came in – earned) $525,000 (Sales before discounts/returns/allowances (DR&A)) $500,000 (Services and/or products you sold, less DR&A) Less Cost of Sales (COS) Gross Profit Gross Margin % -$300,000 - (“Direct” costs incurred, such as labor and materials) $200,000 (Net Sales, less cost of sales (COS)) 40% (Percentage of gross profit from those sales) Figure 3. Adding a few details to this income statement helps paint a more complete picture. Note that because some business is done on credit, when we say “money in and money out,” this does not necessarily mean that we received payment of all our invoices or paid all our bills yet. Looking at this expanded top INCOME section enables us to determine that: We generated $525k in gross sales (what we invoiced). We had $25k in discounts, returns and allowances (DR&A), which reduced our sales for a net sales of $500k. (gross sales, less DR&A). our ‘direct’ cost (cost of sales or COS) of providing those sales was $300k. gross profit on sales is $200k *** (net sales, less cost of sales) *** Your gross profit is what’s leſt over to cover operating ex- penses and overhead. Let’s dive a bit deeper into the cost of sales (COS) issue. If your company were a wholesale distribution business, you would buy products and then resell them at a higher price to make a profit. In this scenario, at the end of each month, you would know how much (and what) you sold, and you’d also know what you paid for those products. What you paid for the stuff you sold would represent your COS. In our distribution business, accountants would likely use the term “cost of goods sold,” instead of “cost of sales,” be- cause there isn’t any direct labor involved in generating these sales. You buy products (goods) and you sell those products (goods), hopefully at a profit. Thus, the term “cost of goods sold.” The same principle is used in a retail business. Note that in this section of the P&L, we refer to our costs rather than “expenses.” This is a very important distinction that helps to understand the COS concept! 26 KEYNOTES APRIL 2021 gross margin (GM) is 40% (respectable for a typical service business). However, if you are a service business, you will likely be doing jobs that involve installations, repairs and other ser- vices that add or provide value. You’ll also likely be selling materials and/or products, either separately (such as over- the-counter sales, if you have a retail shop) and/or as part of your jobs or projects. We need to know what these jobs cost you, and that usually means primarily your direct labor plus materials used on those jobs. We need this cost data separated because, if we did not, we’d be unable to determine whether we were making money (or how much) from selling our services and/or products, before we considered the impact of operating expenses and overhead for our business. Again, it’s helpful to use the term “cost” at this juncture and use the term “expenses” later on. This gross profit (net sales less COS) tells us how much we have left over to pay for operating expenses and overhead such as rent, phone, utilities, salaries, payroll taxes, insur- ance, travel and other expenses of running the business (and also, ideally, some profit). To recap this very important point, remember that only those costs that are directly related to our sales (services and/or prod- ucts sold) are included in COS. It’s imperative that you grasp this important point before proceeding. If not completely clear, please reread the previous section. If we are not making a respectable gross profit, then we need to reexamine our pricing and our job/ order/quotation related costs. If your gross profit is too low, it’s highly unlikely that you will be able to make up for that by suffi- ciently reducing your operating expenses, and you will probably not make a profit. Next, let’s look at that P&L format again, but this time, we’ll move further down to see what comes next: expenses. Now that we’ve recorded our sales and what it cost us directly to provide those sales (COS), we need to know about expenses we incurred in running the business. Such expenses are typically known as operating expenses and are further grouped into sum- mary subcategories of sales, general and administrative (SG&A). WWW.ALOA.ORG
