Managing in the Millennium

Gross Profit

Louis J. Biscotti, CPA, MBA, CITP, Partner

	Once your company has a grasp of what gross profit is all about, it’s time to sophisticate your internal costing procedures and utilize costing methods that are part of the nineties. The first step is not to accept one gross profit percentage as the gospel. It is very important to break down the gross profit by product line (service, division, etc.) to truly understand how each product is contributing to the whole. The next step is to reduce the pool of overhead to the smallest amount possible which enables you to allocate costs to each product and more clearly determine your break-even point. The final step is to utilize modern costing methods to allocate costs to product lines such as activity based costing. Unfortunately, a numerical example is necessary to illustrate these steps. But if you take the time to follow through this example and apply a similar concept in your company, it will pay quick dividends to you. A simple calculator would be helpful.		Total	Product A	Product B
		Sales	$800,000	$600,000	$200,000
		Gross Profit	$208,000	$108,000	$100,000
		Gross Profit Percentage	26%	18%	50%
		It is apparent that Product B is much more profitable than Product A, and if there are more sales of one product than the other (referred to as sales mix), the break-even points change as follows:
One example company has a gross profit percentage of 26% and the total annual overhead (not direct product costs) to run the company is $1 million. In order to determine break-even sales you simply divide the total annual overhead ($1 million) by the gross profit percentage, 26% (.26). The resulting calculation of $3,846,154 is your annual break-even sales and if you divide this amount by 12, you will get monthly break-even sales of $320,513. As I said above, don’t accept this one gross profit percentage as the gospel and here’s why: We now find out that he way we determined our gross profit percentage of 26% was by taking last year’s financial statement which showed sales of %800,000 and gross profit of $208,000 and by dividing the gross profit of $208,000 by $800,000. However, there is more to the analysis. Example Co. has two major products and after analyzing last year’s statement, the following information was developed:			Total	Product A	Product B
		Sales	$800,000	$400,000	$400,000
		Gross Profit	$272,000	$72,000	$200,000
		Gross Profit Percentage	34%	18%	50%
		Now on the same $800,000 of sales, since there are more Product B sales, (which carry a higher gross profit percentage), the overall gross profit has increased to 34%. This results in a new break-even sales amount which again is determined by dividing the overhead of the company ($1,000,000) by the gross profit percentage (now 34%) and the resulting break-even annual sales are now $2,941,176. This amounts to $904,978 less of annual sales required to break-even due to a change in product mix. Therefore, don’t accept the overall gross profit of your Company as gospel and investigate product lines gross profit instead.
			Total	Product A	Product B
The next step in the process is to reduce the overhead pool to as small a number as is possible. This is done by analyzing costs and attempting to allocate them directly to products. For example, if you included %50,000 of commissions in overhead and $20,000 of distribution costs in overhead, you could allocate these to products as follows:		Sales	$800,000	$400,000	$400,000
		Gross Profit	$272,000	$72,000	$200,000
		Less Distribution	$20,000	$12,000	$8,000
		Less Commissions	$50,000	$30,000	$20,000
		Allocated Gross Profit	$202,000	$30,000	$172,000
		New Gross Profit %	25%	8%	43%
Now you calculate your new break-even sales on the lower overhead pool (We started at $1,000,000 less the $70,000 of costs allocated directly to products) or $930,000 and divide it by your new gross profit percentage (24%) to get $3,720,000. So what did we prove? We’ve now reduced the overhead pool by $70,000 and have a better idea of the gross profit from each product as well as a new more meaningful break-even sales amount. You should take this exercise to an extreme by allocating as many overhead costs directly to products as is possible and continue to reduce your overhead pool so that you can know the “bottom line” contribution from each product. The final step of the analysis is sophisticating the cost allocation by utilizing more advanced methods than allocating based on sales volume (the worst) or labor dollars or labor hours. Since technology has reduced the need for as much labor, it is important to utilize other methods to allocate costs, such as activity based costing (ABC). The basic premise in ABC is that activities drive costs and if you analyze the activities that create costs and use that activity basis to allocate the costs, you have more meaningful information. An example of ABC would be purchasing department’s costs. Assume the Example Co. had a purchasing department that cost it $10,,000 and which it included in overhead. By analyzing the purchasing department’s activities, it was determined that 80% of its activities went to Product B and only 20% to Product A due to the large number of orders for Product B. This would mean that $80,000 of the purchasing department’s costs would be allocated to Product B and $20,000 to Product A. This same process would be utilized for receiving, shipping and handling/storage costs.

		Product A	Product B	Product C
We’ve discussed product profitability analysis and costing methods used to sophisticate the gross profit methodology employed in your business. The importance of analyzing gross profit by product line has been illustrated as well as its impact on break-even computations and sales mix. We will now explore the use of a costing method referred to as Activity Based Accounting (ABC). ABC is a modern costing method which does not focus on traditional allocation methods of allocating costs to products based on direct labor or direct materials. ABC utilizes all activities performed to manufacture (distribute) a product by not only taking into consideration traditional costs but also overhead as well. In order to understand ABC, it is necessary to us a simple example:	Price	$160	$125	$105
	Cost of Sales	$105	$90	$53
	Gross Profit	$55	$35	$52
	Gross Profit Percentage	34%	28%	50%
	No. of Units Sold	10,000	15,000	5,000
	The annual profit and loss statement shows the following:
	Sales	Product A	Product B	Product C	Total
	Cost of Sales	$1,600,000	$1,875,000	$525,000	$4,000,000
	Materials
	Labor	$200,000	$450,000	$50,000	$700,000
	Overhead	$100,000	$105,000	$25,000	$230,000
	Total Cost of Sales	$750,000	$787,500	$187,500	$1,725,000
	Gross Profit	$1,050,000	$1,342,000	$262,000	$265,000
		$1,345,000	$532,500	$262,500	$1,345,000
		Product A	Product B	Product C
The costs under the traditional method were determined as follows:	Materials	$20	$30	$10
	Labor	$10	$7	$5
	Overhead	$75	$53	$38
	Total	$105	$90	$53
Since the total overhead was $1,725,000 and labor costs amounted to $230,000, that would mean that for each dollar o labor the product would be assigned $7.50 of overhead. This amount was determined by dividing the total overhead ($1,725,000) by the total labor ($230,000). By applying $7.50 to each dollar of labor, the overhead is then allocated to each product. So for Product A, since labor was $10 per unit, overhead applied would be $75 per unit (found by multiplying 7.5 times each dollar of labor). This “traditional method” results in high volume products getting over costed, which means they’ve been assigned too much overhead costs. The majority of business decisions are made based upon gross profit and costing and if you continue to follow this example you may realize that some critical decisions made by have been incorrect. We will now use a comprehensive example of how much of a difference this can make in the way you look at your product’s contribution to the bottom line. ABC requires that activities which create costs be separately identified and allocated to products based upon some logical criteria. If we utilize the same overhead as shown above and allocate these costs on an ABC basis, the allocations and results would look as follows:

	Product A	Product B	Product C	Total
Equipment Leasing Costs:
Machine Hours of Use	5,000	10,000	10,000	25,000
Percentage/Total Hours	20%