One of the most common types of financial statements used by businesses is the income statement. Also known as a profit and loss statement, an income statement shows a company’s income and expenditures and whether that company is making a profit or loss for a given period.
There is more than one type of income statement, but the one most widely used by businesses, and accepted by the Generally Accepted Accounting Principles (GAAP), is the traditional income statement.
Here’s what you need to know about traditional income statements, including an example of a traditional format income statement, plus how these statements differ from contribution margin income statements.
What Are Traditional Income Statements?
Traditional income statements record both the income and expenses of a business and show how profitable a business was during a particular period, such as a month, quarter, or year. Because a traditional income statement captures all the costs associated with manufacturing a product (both fixed and variable), it’s sometimes referred to as the absorption costing income statement.
The income statement is one of the three most important financial statements in financial accounting, along with the balance sheet and the cash flow statement.
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Calculating the Components of Traditional Income Statements
Here’s a look at the common components included in a traditional income statement.
Sales Revenue
The first section of the income statement provides a summary of the company’s gross sales. In some cases, revenue may be divided into two types — operating revenue (the revenue gained by a company’s primary activities) and nonoperating revenue (the revenue gained from non-core business activities).
Cost of Goods Sold
Commonly referred to as COGS, this is how much it cost to produce all the goods or services that were sold during the reporting period. If a company is a service business, this might be referred to as Cost of Sales.
COGS only includes the cost of items actually sold and only direct costs (such as raw materials, labor, and shipping). It doesn’t include indirect costs, such as overhead. This number may fluctuate each period, depending on how many units were sold.
Gross Profit
Gross profit is calculated by subtracting total COGS from total sales revenue. This is the amount left over after the costs for manufacturing the products have been paid. However, gross profit does not include general overhead expenses.
Selling, General, & Administrative Expenses
Also referred to as “general expenses” or “operating expenses,” selling, general and administrative (SG&A) expenses are expenses the business incurs outside of the costs directly involved in developing its products or services. This may include marketing, advertising, rent, utilities, sales, and accounting. These expenses act as a separate line item from COGS on the traditional income statement.
Operating Income
Once you calculate gross profit, you can subtract those SG&A expenses to calculate operating income. This is the amount the business has available in working capital once all expenses are paid. Operating income tells you how much your business made after subtracting all internal costs (which are costs you can control) but before covering external expenses, such as interest on loans and taxes (which you have less control over).
Interest Expense
This includes the total amount of interest a business pays on any debt, such as different types of small business loans.
Earnings Before Income Tax
This is the business’s profitability before it pays its taxes.
Income Tax Expense
This is how much the business paid in income taxes during the accounting period.
Net Profit
Also known as a company’s “bottom line,” net profit is the total profit a business has earned after subtracting total expenses from total revenue.
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Pros and Cons of Using Traditional Income Statements
So should your company use a traditional income statement? Here’s a look at some of the pros and cons of preparing this type of financial statement as part of your business cash management.
| Pros | Cons |
|---|---|
| Offers complete revenue information and takes all expenses into account | It can misrepresent the value of the company, since it includes money due but not yet received |
| Helps investors and lenders assess a company’s financial health | Doesn’t look at non-revenue factors that can affect a company’s success (such as how wages compare to competitors’) |
| Looking at income statements over time allows you to track overall performance | Requires time and effort to prepare (even if you use accounting software) |
Traditional Income Statements vs Contribution Income Statements
Another type of income statement is the contribution (or contribution margin) income statement.
| Traditional Income Statement | Contribution Margin Income Statement |
|---|---|
| Separates production costs from period/overhead costs | Separates variable costs from fixed costs |
| Uses absorption costing (includes both variable and fixed costs in COGS) | Uses only variable costs when calculating COGS |
| Used externally | Used primarily internally |
While there are similarities between these two types of financial statements, there are also some key differences.The traditional and contribution margin income statements both provide information about a company’s revenues, expenses, and profits (or losses) for a defined period. For both, the top line is revenue and the bottom line is net income. Where they differ is how they arrive at that bottom line.
A traditional income statement separates costs by production/manufacturing costs (both variable and fixed) and period/overhead costs. The contribution margin income statement, on the other hand, separates costs into variable and fixed. Fixed manufacturing costs are considered part of overhead costs and, as a result, are not included in production costs.
Also, a contribution margin income statement deducts variable expenses from sales to arrive at a “contribution margin.” A contribution margin is essentially how much of a company’s revenues are contributing to its fixed costs and net income. Once the contribution margin is calculated, you then subtract all applicable fixed costs to arrive at a net profit for that period.
Typically, a company will use a traditional income statement for external reporting purposes and a contribution margin income statement to analyze the performance of a specific product or product category internally.
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Traditional Income Statement Example and Format
Here’s an example of a traditional income statement for a fictional company that manufactures widgets. Last quarter, the company generated $200,000 in sales. Its COGS was $110,000, and SG&A expenses were $48,200.
| Sales | $200,000 |
|---|---|
| Less COGS | $110,000 |
| Gross profit | $90,000 |
| Less SG&A expenses | $48,200 |
| Operating income | $41,800 |
| Interest expenses | ($600) |
| Income before tax | $41,200 |
| Less income tax | $8,240 |
| Net income | $32,960 |
The Takeaway
A traditional income statement shows business revenue minus expenses and losses for a certain accounting period. It tells you how much income your business netted during that period of time.
Preparing income statements on a regular basis can help you analyze trends within your company, determine if your expenses and/or prices are too high or too low, and make plans for the future, such as whether or not to apply for a small business loan.
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FAQ
How are traditional income statements vs contribution income statements different?
A traditional income statement separates costs by production costs and overhead costs, includes both fixed and variable expenses, and calculates gross profit. The contribution margin income statement, on the other hand, separates costs into variable and fixed costs and calculates a “contribution margin.” Fixed manufacturing costs are considered part of overhead costs and, as a result, are not included in production costs.
What kinds of businesses use traditional income statements?
Any type of business can benefit from preparing a traditional income statement, since it shows whether or not a company has been profitable. In addition, you may need a traditional income statement if you decide to seek outside funding. Lenders and investors often want to see a company’s traditional income statements to learn more about the firm’s revenue, expenses, profitability, and debt.
How do traditional income statements classify costs?
Traditional income statements classify costs by manufacturing costs and non-manufacturing expenses (or operating expenses).
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