In our previous Podcast, we mentioned we were going to start an accounting series for SMEs, well… welcome to part 1.
Profit and Loss Statements:
Profit and Loss statements are the most frequently used reports to measure a company’s financial position so it is very critical to understand it and know how to maintain it. Whether you use Xero or any other software a profit and loss will have four parts:
- Revenue and Income:
Revenue and Income are the areas where everybody focuses, which is totally correlated to sales (it is basically how much you sale). I.E the more sales you do and the more invoicing you do the more revenue your profit and loss will show. The key part to understand is that revenue is only recognized when there is foreseeable monetary gain, let me explain:
Say that you are expecting to sell AUD 10,000 to David. However, you haven’t agreed on anything on the deal. At this stage, even though you know it will happen, you cannot recognize the AUD 10,000 as revenue. 2 weeks later you signed the contract, and provided your service/product and invoiced him. At that stage the money is foreseeable to be paid, consequently, it is recognized as revenue.
That is why a lot of accounting software does not recognize revenue when you sell something but rather when you invoice the service/product supplied. The reason is that an invoice is shown that the inflow of money is legally in written as well as foreseeable.
- Direct Costs (Cost Of Goods Sold):
Direct Costs (COGS) are expenses related to making the product you are making or expenses correlated to producing the service you do. These costs are directly dependent on the number of sales you do, consequently being categorized differently on most profit and loss statements. The important part is that most times this is applicable if you need inventory to provide your service/product. If you run a consulting company that doesn’t expense any inventory to deliver the product then your Direct costs can be categorized as a normal expense.
Inventory Example: Let us say that the product you supply David (following above’s example) is the manufacturing of computers, so you recognized and signed an AUD 10,000 contract and supplied the pcs related to the full amount. However, to deliver such work, you had to buy parts, use machine, etc… this costs accumulated to AUD 5,000. Consequently, your COGS or Direct Costs for this contract are AUD 5,000.
Service Example: In this example, let’s say that the service you supply David is the business consulting, so you recognized and signed an AUD 10,000 contract and supplied 100{02294a49cb707d39fba7c35800b3ba014374aa1ef1f8a15aff36d8ebebbd29a3} of the work. To deliver such work, you and the team spent 50hrs and outsourced another 10hrs of analysis. All up the expenses are of about AUD 2,500 for service costs. These costs, however, are not categorized independently, they are part of the normal expense list.
When somebody talks about gross margin, they mean the subtraction from revenue and direct costs. So: Income – Direct Costs = Gross Margin.
- Variable Expenses
Variable expenses or other expenses are expenses that are normal on the day to day business of the company but are not related to the production of sales (Directly). These are from coffees, to rent and anything in between. The key part of the costs is that people get interested in finding ways of not recognizing these, hence sometimes park of expenses in the balance sheet for future clearing. This is something we don’t recommend any SME to do as it takes a lot of experience to walk through the different accounting standards that regulate this particular transfer (better leave it to the accountant to advise it).
Those are the biggest parts of the Profit and Loss statement and although there are gaps between inflows, revenues, outflows and expenses the P&L is the most commonly used statement to evalutate a company’s position. So understanding its parts and how to maintain it is a key part of our role as SME owners.
If you want to learn more about P&Ls head here!