The “income statement” (or “profit and loss” or “P & L”) presents income and expenses over a period of time. It is important to note that the income statement covers a range of dates, usually an entire month, quarter, or year. The statement starts by listing income or “revenues” or the “top line.”
Direct costs or “cost of goods sold” are then subtracted from revenues to arrive at “gross profit.” Note that direct costs are generally variable in nature; that is, these costs directly correspond to revenues and vary along with them. For example, a store sells a television. The amount that the store originally paid to the manufacturer for the television represents a “cost of goods sold.” This cost is directly related to the revenue that the store earns from the customer. To further illustrate, when the manufacturer sells another television to the store, the labor and materials that go into making it represent direct costs to the manufacturer.
Next, operating or “general” expenses or “overhead,” such as rent and office supplies are subtracted to arrive at “operating profit.” Operating costs are generally fixed in nature, as they tend not to increase in the short-term. For example, a company’s rent often remains the same for months or years at a time. Similarly, operating costs such as rent are not directly tied to any specific sales transactions.
Finally, non-operating and extraordinary items such as interest expense and income taxes are subtracted to arrive at net income or the “bottom line.” An income statement might have the following format:
Gross Revenue (or “sales” or “income”)
Less: Returns & Allowances
Equals: Net Revenue
Less: Direct Costs (or “cost of goods sold”)
Equals: Gross Profit
Less: Operating Expenses (or “overhead”)
Equals: Operating Profit
Less: Non-Operating Expenses
Equals Net Income