Understanding the Income Statement
Basic Accounting - Keeping Your Accounts Straight
What your Profit & Loss (Income) Statement is all about, and the easiest ways to set up your accounts for a small business.
The P&L Sheet Accounts – The Income Statement
There are at least two parts to the income statement, the revenue portion, and the expenses portion. In most small companies the revenue is one line item, and there is no need for anything else.
The expense portion of the statement can be a little more complex. Most businesses will track direct and indirect expenses. Direct expenses are those expenses that can be linked directly to the cost of selling, such as inventory items sold, sales commissions, shipping and packaging for items sent to your customers, and direct manufacturing costs (materials in products, labor and supplies used to produce items). Indirect expenses are those items that cannot be tracked directly to a product sold. This is you “overhead”, and includes rent, interest & bank charges, advertising & promotions, meals & entertainment, travel, conferences, amortization on assets, insurance, licenses, taxes, salaries of staff not linked directly to production (management and administration, non-commissioned sales staff), professional fees, repairs & maintenance, automobile expenses, training, office expenses, utilities, and communication (telephone, internet) costs.
If you read an Income statement, also called a “Statement of Revenue and Expenses”, you will usually see a setup something like the image at the bottom the article.
Look at the image and notice the Gross Income line. This shows you how much you made after you paid for the items or services that you sold, but not including what it costs to operate your business office. Some people will set up their expense accounts without classifying expenses into Cost of Goods Sold, and will, instead, just have one big expense listing. This is a bad idea, because if you track direct and indirect expenses you will get a better picture of how well your business is doing.
For many manufacturing or sales businesses, overhead should be in the range of 10% to 15% of revenue. For services businesses, it can be as high as 25% of revenue. This is a good way to know whether you are keeping overhead costs in line with the size of your business. Too high, and it means that you need to cut back. Is your office too big? So you have too many administrators? Are your interest charges too high? Too low, and there may be a burden on your staff or resources that is making it difficult there to function effectively. Gross margins, then, are much higher than overhead, and costs of goods sold are often in the range of 45% to 80% of revenue, depending on industry profit standards. You should consult with your advisor or accountant on these targets.
Keeping it Simple
While you shouldn’t oversimplify your accounts, you should keep them as simple as possible. Most accounting packages will allow you to automatically set accounts when you first set up the company. Always go through these accounts before you start entering items into the system. If there are items that you think you won’t use, get rid of them! You can always add them later if you feel you truly need them. Make sure there are no duplicates. Remember to keep is simple! Then you will have an easier time with your bookkeeping, and your accountant or other advisors will spend less time dealing with your work, saving you money.
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