The Income Statement is the most frequently used of the primary financial statements. Also known as the Profit and Loss or P&L, the Income Statement measures the results of business operations for a period of time. This contrasts with the Balance Sheet which is the business’ position at a point in time.
The Income Statement reports the company’s profit for a period of time, which might be a month, quarter or year. Revenues are compared with expenses for the period and a profit or loss is the result. The Income Statement can be prepared on the accrual basis (preferred for management purposes), cash basis (often better for tax purposes) or another basis of accounting (unusual).
The Income Statement, however, isn’t just a listing of revenues and related expenses for a period of time. There are important steps along the way. Probably the most important step is the calculation of gross margin or gross profit. Gross margin is viewed by many as the best measure of the value a business provides to customers. If the gross margin is good, then it is just a matter of scaling the business to achieve profitability.
After gross margin (below that subtotal) comes selling, general and administrative expenses. Generally, these are considered overhead. If it were a perfect world, all the components of gross margin would be variable (they would vary with sales volume) and all the components of overhead would be fixed (for the period in question). Of course, things are never quite so simple.
Let’s consider the example of a single shoe store. Gross margin is the price you sell the shoes for less your cost of the shoes, including all costs to get the shoes to your store. The rent and other costs of the building plus the costs of employees plus the costs of marketing are all considered overhead. Since overhead is fixed for the period, if you have a good positive margin on your shoe sales, then profitability is just a matter of selling enough shoes each month.
Now let’s consider a national chain of shoe stores. A national retailer doesn’t usually consider the individual store costs to be overhead. Instead, they look at what is called “four-wall contribution” which is gross margin after the costs of the store building and the employees in the store. Overhead for a national chain comes into play at the regional and national level.
For service providers, it can be even more complicated. After all, there is no “cost of goods sold.” They are selling services, that is, people. Typically the way it is done is to allocate the cost of employees providing services to customers to Cost of Services Sold. Payroll incurred in management and administrative tasks is allocated to overhead. This can mean an allocation of an individual’s pay for the different tasks performed. For example, a manager who also bills some time to customers.
Many costs can go above or below the gross margin line based on circumstances. This can get complicated but it is important to design the system to provide useful information to management for decision making. And this is why accounting is more art than science.
We just barely stepped into the topic here. There are many complicated issues which arise in the accruals of revenues and matching expenses to those revenues. Just the topic of payroll includes payroll related taxes, vacation and sick leave accruals, deferred compensation and benefits, to name a few. Overhead allocation in many industries can be complicated, but a consistent, rational approach can provide an Income Statement that is an important tool for making business decisions.
The term “bottom line” is overused, but the Income Statement is where the term originated. The bottom line of the Income Statement is Net Income and it is the comprehensive profit for the period being measured. It is important, but it is also important to understand the steps along the way.
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