UNDERSTANDING THE PROFIT AND LOSS ACCOUNT

All organisations 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 organisation’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 organisation makes and earns. In
private sector organisations this is often referred to as turnover.
On the simplest level, you create a P&L by deducting the costs of running the organisation 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
Administration and overheads 25
Total Costs 105

Profit (Turnover of £125 minus total costs of £120) 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 organisation.
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 organisation. 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 organisation 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 organisation 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 organisations 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 45

costs of £80)

Other Costs
Administration and overheads 25
Depreciation 10
Total Other Costs 35

Profit (Gross profit of £45 minus other costs of 10

£35)

The profit for the organisation is now £10,000.

Looking at a P&L account on its own never tells you the full story about the organisation. 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.