Basic Profit and Loss Forecast

A profit and loss, or P&L, forecast is a projection of how much money you will bring in by selling products or services and how much profit you will make from these sales. In good times, you use it to ensure that there will be enough money coming in to exceed the costs of providing the goods and services so you can make a solid profit. In tough times, your P&L can play an essential role in showing you what kind of a plan you need to return to break even, so that you'll be able to survive until better times come.

If you use accounting software, such as Intuit's QuickBooks, Sage's Peachtree Accounting, or Accounting Express by Microsoft, it will generate a P&L forecast for you once you enter monthly sales and expense estimates. You can also create your own forecast, using a basic spreadsheet. Just look at the sample P&L below and you'll see how to set it up.

Step 1. Estimate Future Revenue

Start by estimating how much you'll take in each month during the next six to 12 months. No question, this will be a guesstimate. If you're already in business, you can extrapolate from current sales levels and allow for significant seasonal fluctuations and other known variables.

EXAMPLE: Emme owns and operates a consignment shop that sells gently used clothes for women and children. She buys her inventory from moms who bring in their own and their children's clothing to sell. Emme is careful to buy mostly well-known brands (and when possible, high-end ones) that she can sell for a premium.

Emme was selling $15,000 of clothing per month when the economy took a dive. Sales have been down almost 30% lately, so Emme wants to create a morerealistic profit and loss forecast for the upcoming year. She estimates that she'll bring in an average of $10,000 per month in sales over the next year—more at back-to-school time and the holidays, less during the slow summer months.

Step 2. Estimate Your Variable Costs

Now estimate the monthly cost to you of the goods or services you'll sell as part of achieving your sales estimate. These are your variable costs. They're called variable, or sometimes incremental, because they go up or down depending on the volume of products or services you produce or sell. (And in retail, they're called "cost of goods.") For example, if you're a mail-order business, then the more you sell, the more you'll pay for shipping costs.

Other variable costs include inventory, supplies, materials, packaging, and sometimes labor used in providing your product or service. In the case of services, count labor costs as variable costs only if they will go up or down depending on how many sales you make. For instance, if you have to hire independent contractors or temps to cover busy periods, those labor costs are variable. But if you employ a manager, bookkeeper, or marketing employee, you'll have to pay their salaries no matter how much sales go up or down, meaning their wages should be listed under fixed costs (overhead) in Step 4, below.

EXAMPLE: Emme used to spend more than $6,500 per month to buy used clothing to resell. But because sales have been down so much, she will need less inventory and estimates that she will probably spend only about $4,500 per month.

Step 3. Estimate Your Gross Profit

Now simply subtract your average monthly variable costs from your estimated average monthly sales revenue to get your estimated monthly gross profit. This number will let you calculate how much of each dollar of sales you get to keep. From that amount, however, you'll have to pay for overhead costs; anything left over is your net profit.

EXAMPLE: Subtracting her inventory costs of $4,500 per month from her sales estimate of $10,000 per month, Emme estimates her new average monthly gross profit will be $5,500. (This is before subtracting her overhead, which is discussed below.)

Step 4. Calculate Your Net Profit

Your net profit is the most important number you need to determine. This lets you see whether you'll have any money left after paying your overhead costs or, failing that, whether you can at least break even. To arrive at your net profit, make a list of your monthly fixed costs, which are items such as:

• rent
• employees' wages (including payroll taxes, benefits, and workers' comp costs)
• your salary if you plan to pay yourself a regular wage regardless of how profitable the business is (but if, as is typical, you'll just take what's left over after costs are paid, don't include your salary as a fixed cost)
• utilities
• telephone
• insurance
• office equipment
• advertising, and
• accounting, bookkeeping, or tax preparation fees.

Divide any annual expenses, such as insurance premiums, by 12 to get a monthly amount.

To arrive at your monthly net profit (or loss), subtract your average estimated monthly fixed costs from your monthly gross profit.

EXAMPLE: Over the past year, Emme has been able to pay herself $50,000 from the business, but she knows that with sales dropping this won't be possible in the coming year. She guesses she'll need to cut her take-home wages to $30,000—and if she can't bring home at least that amount for living expenses, she won't keep the shop open. So she includes $30,000 in her fixed costs. Emme adds up her total fixed costs, including the following:

• $1,000 for rent
• $100 for utilities
• $4,000 for labor (this includes $12,000 per year for a part-time assistant as well as employment taxes and costs plus $30,000 for her), and
• $100 for insurance (her annual premium is $1,200), and so on.
• The total of her fixed costs comes to $5,500 per month. When she puts one month's numbers together in a spreadsheet, here is what it looks like.

When you are satisfied with your cost estimates for an average month, fill in estimates for six or 12 months. Then, for each month, subtract your total fixed expenses from your gross profit to get the net profit.

EXAMPLE: Emme fills in an entire year of sales estimates, with the usual dip in sales she experiences in summer and then upswings in September when the kids go back to school and in December, traditionally her best month. Then, using her estimate of $4,500 in monthly variable costs and her estimate of $5,500 in monthly fixed costs, she comes up with a net profit for each month. Emme notices that in the summer she'll lose a little over $1,000 per month for a few months in a row, but will make it back up by December.

Creating this new profit-and-loss forecast lets Emme see that she can't count on taking any extra profits out of the business for the next year. And if her sales estimates are too high, she won't be able to take home $30,000 over the year for living expenses. She needs to think long and hard whether it makes sense to drain her savings account and continue toiling for a year in the hopes the the economy will rebound soon and allow her to make a good living again from the store.

Your Gross Profit Margin

It's also useful to know your gross profit margin. Gross profit margin measures the difference between the costs of producing a product or providing a service and what you're selling it for. In short, it lets you know how profitable your products and services are.

To get your profit margin, divide your estimated average monthly gross profit by your estimated monthly sales.

EXAMPLE: Emme divides her monthly gross profit of $5,500 by her $10,000 of sales, to get a profit margin of 55%. Now she knows she will get to keep, on average, about 55 cents of every sales dollar she takes in (before paying for overhead).

Profit margins can be used in many different ways. Some businesses regularly calculate their profit margin to monitor the profitability of their products or services. A decrease in profit margin over time usually means that variable costs have gone up—costs for raw materials, manufacturing, or labor—which should nudge the company to either look for new suppliers or raise prices.

Other businesses use their anticipated profit margin to help them price products or services (and increase profitability). For example, a business that requires a profit margin of 60% and produces a product that costs $20 to make would set the retail price at around $50 ($20 ÷ (100% - 60%)). (However, some experts disagree with this use of profit margin, recommending instead that businesses start with the price they think customers will pay and then making sure the costs are low enough to make a profit.)

Another way to use profit margins is to screen new products and services to sell. For instance, a retail gift shop might decide to add only new products that can be bought and sold at a price that yields a profit margin of 50%.

What's a good profit margin? The answer varies across industries. For example, most airlines have low profit margins, around 5%; the software industry has traditionally had high profit margins, around 80%-90%; wholesalers' profit margins are somewhere in the middle, between 15% and 35%. But without looking at the costs of a company's overhead, such as marketing and administration, profit margins don't give the whole picture of a company's profitability.