GROSS PROFIT VARIATION ANALYSIS

Definition and explanation

Before talking about gross profit analysis, we need to briefly explain, “what is gross
profit?”. Gross profit is the difference between net sales and cost of goods sold and is
computed as a part of income statement or profit and loss account of a business. It is
computed for a specific period by deducting the cost of goods sold (COGS) from net
sales revenue realized during that period. In equation form, it can be presented as
follows:

Gross profit = Nets sales revenue – Cost of goods sold

For example, if the annual net sales revenue of a company is $1,000,000 and its cost of
goods sold is $600,000, the gross profit would be $400,000 (= $1000,000 – $600,000).
The gross profit figure is very important for any business because it is used to cover all
operating expenses and provide for operating profit. The higher the gross profit, the
better it is.

A company or firm may experience a significant positive or negative change in gross

profit. In order to maintain profitability and avoid operating losses, any unexpected or
significant change in gross profit for a period must be timely investigated.

Gross profit analysis is the procedure of finding the causes of changes in gross profit
percentage from budgeted to actual or from one period to another period. The major
purpose of gross profit analysis is to reveal the unexpected changes in gross profit and
their causes so that they can be brought to the attention of management in a timely
manner. A change in gross profit usually occurs due to one or more of the following
reasons:

1. Changes in total revenue for the period due to changes in selling prices of goods
and services.
2. Changes in total revenue for the period due to changes in quantity of goods and
services sold during the period.
3. Changes in proportion in which a multi-product company sells its products
(usually termed as shift in sales mix or product mix).
4. Changes in basic manufacturing cost elements i.e., direct materials, direct labor
and manufacturing overhead.

Procedure of gross profit analysis

The procedure of determining the gross profit variation is identical to the computation of
variances in a standard costing system. However, the gross profit analysis is possible
without the use of budgets or standard costs. In that case, the prices and costs data of
any year may be used as the basis for the computations of variances involved in gross
profit analysis. The usual approach is to use the prices and costs of any previous year
as the basis to find the variations. However, to achieve a greater degree of accuracy
and better results, it is always recommended to employ standard costs and budgeted
figures to carry out the analysis.

Variances involved in gross profit analysis

For performing a gross profit analysis, the standard sales and cost figures (or a previous
year’s sales and cost figures) are used as the basis. The analysis is performed in three
steps. In first step, the sales price variance and the sales volume variance are
computed. In second step, the cost price variance and cost volume variance are
computed. In third step, the sales volume variance and cost volume variance are further
analyzed by computing sales mix variance and a final sales volume variance.

Types of Analysis

Gross Profit Variance Analysis is used to compare actual data (represented here by
2020) with budgeted data, standard data, previous year's data, or base year data
(represented here by 2019).

Normally, these involves the Sales Variance and the Cost variance in consideration of
the price and volume or quantity factors.

1.) 3-WAY ANALYSIS

• Price factor = difference in selling prices x 2020 units

• Cost factor = difference in cost prices x 2020 units
• Volume or quantity factor = difference in units x 2019 gross profit per unit

2.) 4-WAY ANALYSIS

Sales Variance:
• Price factor = difference in selling prices x 2020 units
• Volume or quantity factor = difference in units x 2019 selling price
Cost Variance:
• Price factor = difference in cost prices x 2020 units
• Volume or quantity factor = difference in units x 2019 cost price

2.) 6-WAY ANALYSIS

Sales Variance:
• Price factor = difference in selling prices x 2019 units
• Volume or quantity factor = difference in units x 2019 selling price
• Price-Volume factor = difference in selling prices x difference in units
Cost Variance:
• Price factor = difference in cost prices x 2019 units
• Volume or quantity factor = difference in units x 2019 cost price
• Price-Volume factor = difference in cost prices x difference in units

4.) 4-WAY ANALYSIS PLUS - for two or more products

Sales Mix Variance:

2020 units @ 2019 sales price xx

Less 2020 units @ 2019 cost price xx
Difference xx
Less 2020 units @ 2019 average gross profit per unit xx
Sales Mix Variance xx

Final Sales Volume Variance:

2020 units @ 2019 average profit per unit xx

Less 2019 gross profit xx
Final Sales Volume Variance xx

Example - The Steward Company manufactures to products – product A and product B.

The budgeted and actual data for the last month is provided below:
Required: Using the data of Steward Company, compute:

1. sales price variance and sales volume variance

2. cost price variance and cost volume variance
3. sales mix variance and final sales volume variance

Solutions

1. Sales price variance and sales volume variance

2. Cost price variance and cost volume variance

Interim recapitulation:

3. Sales mix variance and final sales volume variance

Final recapitulation:

Usefulness of gross profit analysis

The gross profit figure is very important for any business and must be closely watched.
The gross profit analysis uncovers inefficiencies in company’s performance during the
period and enables management to take remedial actions to correct the situation.

The manufacturing and marketing departments of business are mostly responsible to

meet or exceed the planned gross profit. In case the business fails to achieve the
desired gross profit, the manufacturing department must explain the changes in
manufacturing costs and marketing department must explain the changes in prices,
decrease in number of units of each product sold and/or shift in sales mix during the
period. This way, the gross profit analysis brings together the two major functional areas
of the business and focuses on the need of more study by these two departments.