Gross profit analysis is designed to pick apart the reasons why the gross profit margin changes from period to period, so that management can take steps to bring the gross margin in line with expectations. A decline in gross profits can be an indicator of serious problems, so the figure is closely watched. Gross profit is calculated as:
Gross profit = Sales - direct materials - direct labor - manufacturing overhead
A change in gross profit can be caused by any of the following events:
- Sales prices have changed
- The unit volume of items sold have changed
- The mix of products sold has changed (which alters the gross profit if different products have different gross margins)
- The purchase price of direct materials have changed
- The amount of direct materials required has changed, which in turn can be due to:
- Altered scrap levels
- Altered spoilage levels
- Altered amounts of rework
- Changes in the design of the product
- The amount of direct labor has changed, due to altered efficiency levels
- The cost of direct labor has changed, which in turn can be due to:
- Altered overtime levels
- Changes in the mix of employees having different pay rates
- Changes in the amount of shift differentials paid
- Changes in the equipment used
- Changes in the design of the product
- The amount of fixed overhead incurred has changed
- the amount of variable overhead incurred has changed
The preceding list is not comprehensive, since gross profit analysis may also uncover problems in such as areas as late or double-counted inventory, incorrect units of measure, and theft. Also, the broad scope of this list of events should make it clear that controlling gross margin requires the input of many parts of a business, including the engineering, materials management, sales, and production departments.
A gross profit analysis involves comparing the gross profit for the period being reviewed to either the budgeted level or the historical average. If you are using standard costing, then you can use any of the standard cost variance formulas for gross profit analysis, which are:
- Purchase price variance. The actual price paid for materials used in the production process, minus the standard cost, multiplied by the number of units used
- Labor rate variance. The actual price paid for the direct labor used in the production process, minus its standard cost, multiplied by the number of units used.
- Variable overhead spending variance. Subtract the standard variable overhead cost per unit from the actual cost incurred and multiply the remainder by the total unit quantity of output.
- Fixed overhead spending variance. The total amount by which fixed overhead costs exceed their total standard cost for the reporting period.
- Selling price variance. The actual selling price, minus the standard selling price, multiplied by the number of units sold.
- Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to be sold, multiplied by the standard selling price.
- Material yield variance. Subtract the total standard quantity of materials that are supposed to be used from the actual level of use and multiply the remainder by the standard price per unit.
- Labor efficiency variance. Subtract the standard quantity of labor consumed from the actual amount and multiply the remainder by the standard labor rate per hour.
- Variable overhead efficiency variance. Subtract the budgeted units of activity on which the variable overhead is charged from the actual units of activity, multiplied by the standard variable overhead cost per unit.
If you are not using standard costs, you can still use the preceding variances, except that you use budgeted or historical cost information as the baseline, rather than standard costs.
The gross profit analysis reported to management should describe the total variance from expectations, and then itemize the exact reasons for the differences. The report should contain actionable items, so that management can identify specifically what is wrong and proceed to fix it. An even better gross profit analysis is one that clusters identified problems into categories and shows the frequency of occurrence of the categories over time. Doing so shows management which problems are causing the most trouble on a repetitive basis, and which are therefore most worthy of attention.
While gross profit analysis is important, it only covers product-related costs. Thus, if you want a comprehensive review of all aspects of a company's financial results, you must also evaluate all costs of selling and administration, as well as all financing and other non-operational expenses.
Gross profit analysis also ignores the amount of investment in working capital and fixed assets in proportion to sales. That is, it does not account for the efficiency of asset usage in creating gross profits.