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All organizations need to be able to assess whether they are making a profit or running at a loss. This is done by producing a profit and loss account, sometimes known as the P&L. Here we explain how to read and construct a P&L to help you broaden your understanding of your organization’s financial performance.
Although the P&L can look complicated, once you understand the basic layout and rules it is relatively easy to read.
The starting point for any P&L is the sales and income that the organization makes and earns. In private sector organizations this is often referred to as turnover.
On the simplest level, you create a P&L by deducting the costs of running the organization from its income. This enables you to see if you have a profit or loss for the period under review.
A worked example is useful to show this in action. Suppose turnover or income for a given period was £125,000 and the cost of the operations over the same period were:
- materials - £35,000
- wages and salaries to produce the goods - £45,000
- administration and other overheads - £25,000
The profit and loss account would be:
Item
£ (000)
Turnover
125
Cost of Sales
Materials
35
Wages and salaries
45
Adminstration and overheads
25
Total Costs
105
Profit (Turnover of £125 minus total costs of £105)
20
So, our profit in this example is £20,000. (Note how we have marked the top of the right-hand column to show that the figures are in thousands, e.g. £125,000 becomes 125.)
As we outlined, this is a very simple example of a profit and loss account. In a normal profit and loss account it is usual to see a number of different categories for costs so that it is clear how much has been spent on each item. For instance, all the costs that refer directly to sales, or production and those that are more general to the whole organization.
You will often find the term ‘gross profit’ in a P&L and this refers to the profit generated before meeting the costs of administration and overheads. This is the profit after the direct costs have been deducted from the sales income.
It is important to remember that a profit and loss account is not the same as recording what happens to cash in an organization. It is a record of all the income and expenses incurred in the timeframe covered by the accounts.
One of the expenses that needs to be included in the P&L is the cost for items (fixed assets) bought by the organization that have a lifespan greater than one year. In accounting terms you don’t have to account for the full cost when the asset is purchased and you can account for it over the lifetime of the asset.
For example, an organization purchases £30,000 of computers and it is thought that the lifespan of the computers will be three years. In accounting terms you can charge £10,000 against the P&L for each of the three years. This allows organizations to smooth the impact of investing in new fixed assets and it appears in the P&L as an item called depreciation.
If we take the P&L example from earlier, we can expand it to show the gross profit figure and the depreciation. The profit and loss account looks like this:
Item
£ (000)
Turnover
125
Cost of Sales
Materials
35
Wages and Salaries
45
Total Direct Costs
80
Gross Profit (Turnover of £125 minus direct costs of £80)
45
Other Costs
Administration and overheads
25
Depreciation
10
Total Other Costs
35
Profit(Gross profit of £45 minus other costs of £35)
10
The profit for the organization is now £10,000.
Looking at a P&L account on its own never tells you the full story about the organization. You may want to compare it with the previous year to see if there are differences. For example, you might think that the finances are looking good but, in fact, you have made a lot less profit than the previous year. You may often find that profit and loss accounts contain both this year’s figures and those of the previous year to enable you to track the financial performance over time.
