I have found that many startup founders and even some executives in larger technology companies are not familiar with the structure of the income statement, also known as profit & loss statement, or short P&L.
Why the P&L is Actually Quite Interesting
Every one who works on business model design or who is in a leadership role at a technology company should understand a few basic concepts about the P&L, because
- the P&L provides information on the cost structure of a business
- this helps you understand your own business, that of competitors (in case you have competitors that need to report their financials), and that of industry leaders who use a similar business model as you do (for inspiration)
- the cost structure is very much intertwined with the business model of a company
- and therefore, it helps you understand which freedoms you have (and don’t have) in evolving or changing your business model
P&L – Quick Overview
So, without much further ado, here is a simplified view of the P&L:
The P&L starts with total revenue, also called the “top line”
Then, you subtract all the cost of revenue, also called “cost of goods sold”, or sometimes even “cost of sales”: these are all the costs that vary with the amount of goods and services you sell. For example, if you produce a physical good, all the manufacturing costs go here, e.g. labor and the cost of parts that you buy.
What’s left at this stage is called the gross profit.
Then you subtract all other costs of normal business operations. These costs are somewhat fixed because if you have a sudden drop or spike in sales, these costs do not change immediately. But of course, as the company grows substantially, these costs will increase as well. They are just not directly and in the short term related to sales volume.
Typically, that section includes:
- research & development (R&D): e.g. if this is a SW company, the personnel costs for
development and testing go here
- sales & marketing
- general & administrative (G&A): salaries of the CEO, IT, HR, rent for office space
- other operating costs, e.g. appreciation/ depreciation of capital goods (such as IT equipment).
After subtracting, these “fixed” costs, what’s left is operating profit; it reflects the profit that normal, ongoing operations generate.
Then, you add (or subtract) all remaining line items that are considered “special”, not part of of normal operations, e.g. interest earned on company cash (or interest paid on company debt). Or proceeds from selling off a part of the company or other special stuff. Oh, and taxes.
The result is then net profit, also called the “bottom line”.
Cost Structure = Looking at Percentages
Investors or analysts looking at multiple companies will analyze various metrics as % of revenue: especially gross profit, operating profit, and net profit. Profit percentages are called margins, e.g. operating profit margin.
The fictional company in the example P&L has a gross margin of 25%, an operating margin of 7% and a net profit margin of 4%, which is a reasonable for a company operating in a highly competitive traditional industry, such as discount retail stores.
With this cost structure, there is obviously no leeway to experiment with alternative business models, such as freemium: giving away the basic product or service for free, with only a minority of customers paying for premium services is not an option here.
The margin metrics are so important that financial information sites make them easily accessible for publicly traded companies.
For example, Yahoo! Finance provides data for these metrics in the “Key Statistics” section for a stock, such as Microsoft: the gross profit is given in US$ (gross profit margin can be calculated using total revenue), operating margin and net profit margin are provided directly.
The other major sections in the P&L – cost of revenue, fixed costs, and the total of “special” line items, all as % of revenue – can be deduced from these three key metrics.
Understanding Typical Cost Structures
To figure out the typical cost structure for an industry or a certain business model, one can analyze publicly available financial information from companies that are traded on stock exchanges.
For a more detailed analysis of the full financial information, the most recent annual report plus the latest quarterly report are useful. An annual report can easily be more than 100 pages long, and it includes a lot of useful information: full P&L and other financial statements, plus additional information on the company (e.g. revenue structure), on the market, and market risks.
Full company reports are usually available on a company’s web site in the Investor Relations section.
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