Why Profit and Loss Matters
A business can generate substantial sales and still have little money left after costs are considered. For example, a business might make $10,000 in monthly sales, but if $6,000 goes toward costs directly related to the products or services sold and another $3,500 goes toward operating expenses. After subtracting these expenses and costs, only $500 remains from the monthly sales.
This is why looking at revenue alone does not tell you whether a
business is profitable. You also need to consider the costs of
generating those sales and the expenses required to keep the business
operating. A profit and loss calculation provides a simple way to bring
these figures together. To make this simple:
Revenue − Costs = Profit or Loss
For small-business planning, however, it is useful to separate costs into direct costs and operating expenses. This makes it easier to see where the money is going and which part of the business may need closer attention.
How the Profit and Loss Calculation Works
A monthly profit and loss calculation starts with the amount of sales revenue the business expects to generate. You then subtract the costs directly connected to what you sell, followed by the other expenses required to operate the business.
The calculation can be summarized as:
Sales Revenue − Direct Costs = Gross Profit
Then:
Gross Profit − Operating Expenses = Estimated Operating Result
The estimated operating result shows what remains after the direct costs and operating expenses included in the calculation have been considered. It is a useful planning figure, but it should not automatically be treated as the business owner's final take-home income or as a complete accounting profit figure.
Sales Revenue
Sales revenue is the income a business generates from selling its products or services before deducting any costs or expenses.
For a monthly calculation, you might estimate that a business will
generate $8,000 in sales. The important point is to use a reasonable
estimate of a normal month, rather than the highest sales you hope to achieve.
For example, if a business normally expects to sell 400 units at $20 each:
400 × $20 = $8,000 sales revenue
Your revenue estimate becomes the starting point for the rest of the calculation.
Direct Costs
Direct costs are costs that are directly connected to producing or delivering the products or services a business sells. In other words, these are costs that would be immediately eliminated if you stopped offering that specific product or service. If cutting the product cuts the cost to exactly zero, it is a direct cost.
For a business that sells physical products, direct costs might include the materials used to make the products, products purchased for resale, packaging used specifically for those products, and labor directly involved in producing them. For a service business, direct costs might include payments to the people who provide the service, as well as other costs that arise specifically from delivering the service.
For instance, consider a business that sells handmade bags. The fabric, zippers, and other materials used to make the bags are direct costs because they are directly associated with the products being sold. If the business also pays someone specifically to make the bags, that person's direct production labor may also be included as a direct cost.
After direct costs are deducted from sales revenue, the amount
that remains is gross profit:
Gross Profit = Sales Revenue − Direct Costs
Operating Expenses
Operating expenses are the costs of running the business that are not included in its direct costs. These expenses support the business as a whole rather than being directly tied to the production or delivery of a particular product or service.
Common operating expenses include rent, utilities, marketing, software subscriptions, insurance, professional and administrative services, maintenance, and other regular costs required to keep the business operating.
For example, a bakery may need to pay rent for its shop whether it sells 100 or 500 loaves of bread during a month. The rent is necessary for the business to operate, but it is not a direct cost of producing a particular loaf. Similarly, the business may pay for accounting software or advertising even though those expenses cannot be directly assigned to a specific product sold.
Once gross profit has been calculated, operating expenses are deducted
to determine the estimated operating result:
Estimated Operating Result = Gross Profit − Operating Expenses
This distinction between gross profit and estimated operating result can help you understand where a problem may be occurring. If gross profit is already low, the costs directly associated with producing or delivering what you sell may need closer attention. If gross profit is reasonable but the operating result is low, the larger issue may be the recurring expenses required to operate the business.
Gross Margin and Operating Margin
Profit and loss calculations can also be expressed as percentages of revenue.
This makes it easier to understand how much of each dollar of sales remains
after certain costs are considered.
Gross Margin = Gross Profit ÷ Sales Revenue × 100
For example, if sales revenue is $8,000 and gross profit is $5,000:
$5,000 ÷ $8,000 × 100 = 62.5%
The business has a gross margin of 62.5%, meaning $0.625 of every dollar of revenue remains after the direct costs included in the calculation.
You can also calculate the operating margin:
Operating Margin = Estimated Operating Result ÷ Sales Revenue × 100
If the estimated operating result is $1,500:
$1,500 ÷ $8,000 × 100 = 18.75%
The operating margin is therefore 18.75% based on the costs included in the calculation.
These percentages provide another way to examine the same calculation. They can be particularly useful when comparing different months or considering how changes in sales and costs affect the business.
What About Paying Yourself?
The amount of money a business must pay its owner is an important consideration, but owner compensation, salary, or withdrawals can be treated differently depending on the business structure and accounting approach.
For planning purposes, it can be useful to ask a separate question: How much money does the business need to provide for the owner's personal income each month?
A business could have a positive estimated operating result while still not providing enough money for the owner's personal needs. Keeping this consideration separate helps distinguish the business's operating result from the amount the owner may need personally.
What Happens if Sales Change?
A profit and loss calculation is based on assumptions, so it can
be useful to examine what happens when those assumptions change.
For example, suppose your expected monthly revenue is $10,000.
You could examine a simple scenario where revenue is 20% lower:
$10,000 × 0.80 = $8,000
You could also examine a scenario where revenue is 20% higher:
$10,000 × 1.20 = $12,000
If the other costs remain unchanged, the estimated operating result will also change. This gives you a simple way to see how sensitive the result is to changes in sales.
What Should You Examine Next?
A profit and loss calculation becomes more useful when you look beyond the final number.
Start by examining your sales assumption. Is the expected monthly revenue based on a reasonable estimate of what the business could normally sell, or does it depend on an unusually strong month?
Then look at your direct costs. Consider the prices of materials or inventory, how much material is used, packaging, production efficiency, waste, and other costs directly associated with generating sales.
Next, look at your largest operating expenses. A cost that takes a large share of revenue may have a greater effect on the operating result than several smaller expenses combined.
You can also consider whether your pricing and sales volume are appropriate for the business. A change in price, number of units sold, direct costs, or operating expenses can significantly affect the result.
What a Profit and Loss Calculation Does Not Include
A simple profit and loss calculation is useful for planning, but it is not necessarily a complete accounting statement. Depending on the business and accounting method, other items may need to be considered, including taxes, depreciation, the accounting treatment of loan interest and principal, owner compensation or withdrawals, one-time expenses, inventory accounting, and other financial items
For this reason, an estimated operating result should be treated as a planning figure based on the information and assumptions included in the calculation, rather than as a complete measure of final take-home profit.
Ready to work through it?
Once you understand how the calculation works, you can apply it to your own business idea or current business.
The Profit & Loss Analyzer can help you organize your monthly sales, direct costs, and operating expenses in one place and calculate the resulting gross profit, margins, and estimated operating result. You can also examine your largest operating expenses and see how the result changes under simple higher- and lower-sales scenarios.
Open Profit & Loss AnalyzerKeep Learning as You Go
Understanding profit and loss is one part of understanding a business. As you continue planning, you can also examine pricing, cash flow, break-even points, startup costs, and other factors that affect how a business operates.
You don't have to have everything figured out today. You just need a clearer next step.