How to Compute Profit for a Service Provider Company

A service company is one that sells services to its clients. Different from manufacturing and trading companies, it provides services or works of labor rather than tangible products to its customers. Accounting firms, law firms, schools, janitorial and hotel companies are some of examples of service provider companies. As the operation of this kind differs from the others, the computation and preparation of its statement of operation also differs. Since a service company sells services, we need to compute its cost of services, as computing cost of goods sold in a manufacturing and trading firms which sells goods to its costumers. But in all kind of firms, we compute direct and indirect costs to determine gross and net profit.

The revenues of a service company consist of all its receipts and receivables from rendering services during the period less all refunds associated from them. Unearned revenues collected during the period are not included because they are not related to the services rendered during the period. This concept is called accrual basis. Accrual accounting means “revenues are recognized when earned regardless of when they are received and expenses are recognized when incurred regardless of when they are paid”. Let us consider a school entity for example. School revenues are generated from educational services the school provides to its students. School fees are recognized as revenues in the school term which the services are rendered regardless of whether these fees are collected or not. School fees collected which pertains to the next school term are not recognized as revenues earned for the current school term but recognize as liabilities in the form unearned revenues.

The costs of services of a service company composed of all the direct costs attributable to the services provided by the company. It means that all costs which are directly related to the services provided by the company are recognized and included in the cost of services. For a school, cost of services includes all cost directly attributable to the educational services it provides. These consist of instructors’ fees, educational supplies and materials, school building and equipment depreciation, school building rental and other costs directly related to educational services. The difference between revenues and cost of services is what will become our gross profit.

All indirect costs and expenses are recognized as expenses to be deducted to gross profit to arrive at our net profit. These are expenses that are not directly attributable to the services provided to customers. For an accounting or a lawyer firm, the salaries of the HR personnel and other cost and expenses that are not directly attributable to the accounting and legal services provided by these firms are examples of indirect expenses. The salaries of the school’s accountant and cashier, depreciation of its administrative building and taxes are also examples of indirect expenses that should be separated from the cost of services. These expenses are also called operating expenses, general and administrative expenses or indirect expenses. These expenses including the income tax expense deducted to gross profit will result us the net profit of a service provider company.

The presentation of statement of income described above is called functional presentation. It classifies expenses according to their function as part of cost of services, administrative expenses and other operating expenses. This presentation provides more relevant information than the presentation of expenses by nature. Functional presentation provides as the computation of gross profit which is important in analyzing our cost of sales or services and their related revenues.

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