An income statement is the summary of a business’s revenues and expenses over a period of time. In its basic form, an income statement looks like this. It’s a summary of a business’s revenues and expenses over a period of time. When we take our total revenue and subtract our expenses from it then we work out our profit or our loss.
We make a profit when our revenues exceed our expenses and on the flip side, we make a loss when our expenses are more than the income we’ve earned. This is why the income statement is also known as the profit and loss statement or the P&L for short. It lays out a roadmap for how we ended up at the bottom line our profit or loss. The income statement always covers a period of time which could be anything that we want it to be but typically we run it for a month a quarter or a full year.
Revenues less expenses make us a profit or a loss. There are many different types of revenue. If we were running a business that sells physical products then we might want to call these product sales instead or if we provide services we can call this our services rendered.
Expenses in businesses can be in two categories
Our direct costs of doing business are the costs which we can directly trace through to the products we’ve sold or the services that we’ve provided. For a business that provides services we might call this our cost of services and if we sell physical goods then we can call this our cost of sales or our cost of goods sold. Direct costs like these are variable costs which increase in direct proportion to the sales that we’ve made. If you were running a retail or a wholesale business then these would include things like the original purchase price of the product that you’re reselling or if you’ve run a manufacturing business then this would include the cost of your raw materials or the direct labor cost that went into producing your product. As we make more sales we incur more of these direct costs.
When we take our revenue and deduct our direct costs of doing business we get to our gross profit. There are different types of profit. Our gross profit is a really useful tool that allows us to measure the efficiency of our production and sales process.
Indirect costs are the costs of running a business that can’t directly be traced back to the production of goods or the provision of services. It is sometimes called overheads. Overheads can include fixed costs like rent employee salaries, insurance costs, administrative expenses, legal costs accounting costs, marketing costs, depreciation, and amortization. Fixed costs tend to remain the same they bear no correlation at all to the sales that your business has made. However, not all overheads are fixed. Variable overheads can loosely correlate with a business’s sales although they can’t be directly traced back to the production of goods
or the provision of services. These include things like advertising costs which can indirectly drive sales and sales commissions. Utility costs could also be considered a variable overhead in a manufacturing business because these can increase as we ramp up production.
When we deduct our indirect costs of doing business from our gross profit, we come to our operating profit. Operating profit measures the net income that we’ve generated from operations this is the residual amount that’s leftover, after deducting all of our direct and indirect costs of doing business.
We should note that this is our basic income statement which helps us measure a business’s financial health. It does that by giving us the means to compare our financial performance against comparative accounting periods.