Frank Blau
Contributing Writer

The Profit & Loss Statement shows the results of business operations for a stated period of the fiscal year – month, quarter, entire year, etc. It summarizes the relationships of income and expenses that occur between balance sheet dates, and details changes in the net worth of a company.

Analyzing the Profit & Loss Statement (henceforth referred to as “P & L”) is vital to understanding the day-to-day operation of one’s business. And frankly, producing a P & L only once a year just isn’t enough. A whole year is plenty of time for a business to go bankrupt before the owner even knows what hit him! It should be done monthly, or at a minimum, quarterly.

Understanding the financials, and getting frequent reports, enable the person in the pilot’s seat to make midcourse corrections that may be necessary to prevent disaster. You need snapshots taken once a month, at least once a quarter, to tell you whether you are heading into a mountain before you get right on top of it.

P & L Content: Attached is a reproduction of the P & L statement of one of my clients, for a service and replacement division of the company. I’ve used this comprehensive format for many years to monitor the financial health of my own business, and have recommended its use to many friends and consulting clients.

It shows how things stood with the business for the month of August 2009. The prior month’s figures are shown in adjacent columns, followed by year-to-date figures. Then come the comparable monthly and year-to-date figures from the previous year for comparison.

Highlighted are some of the key data categories: Net Sales, Cost of Sales – these are Direct Costs consisting of material, labor, permit fees and other direct expenses charged to specific jobs – Gross and Net Profit, (called Net Operating Income in this case).

Note that this statement is arranged so that overhead expenses are itemized before being totaled and subtracted from gross profit on sales. To save space, we only listed the first and last overhead categories on the printout, “Salaries” and “Miscellaneous.” The original printout also included breakdowns of eight other major categories of Overhead – Rent & Utilities, Maintenance & Maintenance Contracts, Insurance, Small Tools, Advertising, Truck Maintenance, Office and Depreciation. These were further broken down into about 75 different line items of overhead spending.

The exact composition of a P & L statement will vary depending on the type of business, but I’m of the opinion that the more detail it gives the better. For example, a general category of “Advertising” will appear on the P & L of most businesses, but to get a useful picture of how those dollars are spent, you need to further break it down into Yellow Pages, newspaper, radio, TV, specialty items, etc.

Interpreting The P & L: There is no limit, especially when you have a computer, to the extent of the analyses you can do. You can prepare a P & L statement to indicate the profit or loss on every job, or if that’s too much paperwork, for a multitude of jobs of the same type. You could compare, for instance, the profitability of remodeling versus new construction, or of jobs in one part of town versus another, or of various types of customers, etc.

The procedure will help you identify those jobs which produce inadequate profit margin or none at all. Further scrutiny of the line item details will reveal why certain jobs are more likely to suffer losses and why others tend to be very profitable.

The reason for all the detail is to track where costs are becoming excessive. Once you identify a specific area where spending is getting out of hand, you can apply corrective measures.

There are two very important readings to take from the P & L, preferably each month, because they signal trends that can spell prosperity or doom over the long run.

One is to keep an eye on gross profit percentage, calculated by subtracting total direct cost of sales from net sales. Your margins must be high enough to cover overhead and a reasonable net profit. The desirable percentage of gross profit will vary among different businesses and market activities, but the percentages should be stable for the same time periods and for the same activities.

An erosion in gross profit margin reflects price-cutting, or failure to pass along expense increases. It can make or break your company, so if you observe erosion taking place over a period of time, sound the alarm and take action.

The second key is Net Income or Net Profit. Our sample statement shows the computations “B/4 Taxes.” I prefer to show what’s left after taxes, when possible.

This reflects the portion of sales dollars the owner keeps for the risks and headaches he has incurred. These dollars also are referred to as Retained Earnings, the money needed to grow one’s business, to replace worn-out equipment, purchase or lease computers, open showrooms, and to achieve the basic goal of entering into business for yourself – namely, to earn more money than you can by working for someone else!

Observe that Net Operating Income for August on our sample P & L amounts to $83,566.43 or 28.24{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of Net Sales of $295,917.62. After subtracting profit sharing and bonus allocations from Net Operating Income, Net Income B/4 Taxes is a spectacular $56,178.31 or 18.98{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of Net Sales. True, August was an exceptional month for this firm, but even the Year-To-Date “bottom line” figure of $154,865.46 pre-tax dollars, amounting to 9.15{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of sales is impressive compared with the industry wide average of 2.1{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} before-tax net profit.

Not long ago this business was in deep financial trouble. My advice to them was to become “numbers crunchers,” because business is definitely a branch of mathematical science. Realizing that is the first step towards working smarter – not harder.

Beyond The Bottom Line: I’ve always believed it’s important to know where profit dollars emanate from. The P & L tells you exactly where and how.

The traditional notion is to look for “the bottom line,” or on our sample sheet Net Income B/4 Taxes. One must go one step further and understand that profit is earned on each line item of direct and indirect cost.

Thus, if we follow our Cost of Sales ledger down the line on the sample P & L, we find that net dollars earned Y.T.D. on material cost is $64,669.03, while profit earned on labor cost is $82,177.50.

What does this mean? For one thing, it says that if material cost were equal to labor cost, an additional $17,508.47 would have been earned for the Y.T.D. period, and that is about the easiest way to add to profits.

Remember, the same amount of labor is expected to install a $65 water closet as one costing $265. A whirlpool bathtub does not involve significantly more labor than a “plain Jane” tub, energy-saving boilers no more than energy guzzlers and so on. You get the idea. It also makes more sense to sell complete bathrooms and kitchens with all the merchandise that going into them, than being a subcontractor selling labor only. Again, it’s a matter of working smarter, not harder.

Also note that more profit is earned on overhead – $189,797.26 Y.T.D – than on direct cost ($148,283.10). Put another way, 56.14{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of total Y.T.D. net profit before allocations was derived from overhead costs, 24.31{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} from labor costs, 19.12{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} from material costs and .43{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} from permit fee costs.

By The Numbers: Let’s determine how these Y.T.D. line item profit dollars were earned.

Not that Y.T.D. Net Operating Income is $338,079.84. This is derived by adding each line item of direct and indirect (overhead) net profit margin. It amounts to 19.98{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of net sales of $1,692,025.69. This means that each line item of direct and indirect (overhead) cost equals 80.02{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of the selling price of each line item.

Let’s apply the basic math to Y.T.D. line item #40, “Administrative Salaries.”

1)      $32,405.40 in Admin. Salaries equals 80.02{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of the selling price, an unknown X.

2)      $32,405.40 divided by 80.02{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} equals X, the selling price, or $40,497.03.

3)      19.98{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} (.1998) x $40,497.03 equals $8,091.63, the net profit earned on administrative salaries.

Net Y.T.D. operating income of $388,079.84 is derived by adding each line of direct and indirect (overhead) net profit margin.

Common Mistakes: One of the most common faults I find with P & L statements is improper entry of direct and indirect cost items. The attached statement shows an actual income statement prepared by one of my clients. It is grossly oversimplified by typical of what I find with most PHC contractors and other small businessmen.

The “Expenses” are all lumped together with no distinction between direct and indirect costs. The highlighted items are those that can be assigned as direct costs to each job. Other entries fall into the overhead category.

The distinction is important. Direct cost of sales include all items of expense that can be identified as applying to a particular project or projects. This information tells you something very different than what you find out from overhead totals. If your direct costs get out of line on a particular kind of work, it may be a signal that you need to get out of that sector of the market or approach it in a different way. Overhead, on the other hand, speaks to the way you spend money supporting the business in general, not any particular aspect of it.

This erroneous statement was prepared by a CPA firm. It looks like it was done late on a Friday afternoon by an accountant who had a hot date that evening! I’ve seen many statements such as this, which shows me that many CPAs do not understand the construction industry. It is virtually impossible to know what is going on in the business with a P & L in this format. How can a contractor monitor direct costs when there is none to be identified?

Also absent from the statement is any entry for proprietor and office salaries, even though the contractor serves as president and his wife is the vice president. She puts in 30-40 hours a week for nothing. How dare the owner treat his wife as a slave!

The lousy statement does show that “Wages” of $17,011.22 were paid to the working owner for the five month period statement. This projects for the entire fiscal year to an income of $40,827 for the owner – and must also support his wife.

I know many journeymen who make more than that. Where’s the reward for owning one’s business? The compensation for risk, long hours and daily crises? Where’s the reward for his wife? Where are the retained earnings to be used for business expansion?

It’s difficult for all of us to forge ahead when there are so many within the industry who under price themselves. I believe that this situation is widespread and the single biggest reason why market prices for PHC goods and services are nowhere near where they should be.

On Strike: I’ve tried to reconstruct this person’s statement as it should be, also shown on the sheet attached. I’ve left blank the lines for the owner and office (wife’s) salaries. Use your imagination to fill in whatever numbers you think appropriate, then observe what the bottom line profit might be, if any.

Aha! You caught me. I’ve left the owner’s $17,011.22 in wages, so you’re thinking he’s not entitled to a salary.

You are mistaken. Because he still works with the tools, it’s okay for him to categorize his pay as wages instead of salary, and appropriate to assign it to direct cost.

But he also should draw additional income as a corporate officer. As president, he spends innumerable hours on activities that include estimating, purchasing, sales and more that cannot be counted toward individual jobs. The $40,827 he earns as a journeyman working in the field is fair pay, comparable to the going rate earned by full-time union plumbers in my part of the country.

But I’ll tell you something – those journeymen would go on strike instantly if contractors insisted that they put in an additional 20-30-40 hours a week doing estimating, sales, paperwork, etc., without extra pay. And I wouldn’t blame them. If a contractor doesn’t compensate himself for the grueling aspects of owning and running a business, he might as well go work for someone else and give up all the headaches.

There is, of course, $12,357.43 in net income left over. Projected over a year’s time that would amount to $29,658. Most PHC contractors think in terms of pocketing that profit, which would boost this man’s income to a somewhat more respectable level.

However, that’s pre-tax money. A big chunk of it gets taken off the top by Uncle Sam. Maybe the contractor can pocket the rest, but then where does the money come from if his business requires a new truck, or a computer, or some other capital investment.

So, while 19.35{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} as a bottom line looks pretty good on this P & L statement, it’s an illusion. Just compensation for this owner and his wife would easily turn those profits into a loss. Let’s say, for example, that the president draws a salary of $10,000 for the five-month period in question – a miniscule executive salary. And let’s say he pays his wife, the company vice president, $8,000 for the same period of time, also low pay.

What happens is the $12,357 in profits turns into a deficit of almost $6,000. Yikes! This company would be in trouble. It is an all too familiar reflection of the real world in the PHC industry. I encourage all of you to learn from these mistakes and do all in your power to acquire the managerial tools to avoid repeating them.

Good luck, good health, and God bless.

The P and L Statement