Big Picture in Focus: ULOb.

Analysis of Gross margin or gross profit

Metalanguage
The most essential terms of this section has been defined below for you to have a better
understanding of this section in the course. You are to refer also with the definitions set
in the previous unit.

1. Gross Profit or Margin. Gross profit is the difference between sales and cost of
goods sold.
2. The quantity factor refers to the change in gross profit due to difference in units
sold.
3. The price factor refers to the change in gross profit due to the difference in
selling price.
4. The cost factor refers to the change in gross profit due to the difference in cost
price.

Essential Knowledge
ANALYSIS OF VARIATION IN GROSS PROFIT

In our discussion of horizontal analysis, we learned how to compute absolute and

percentage changes in each of the components of financial statements. These
statements include the income statements. Absolute and percentage changes in sales,
cost of sales, gross profit, expenses and income were determined.

Such changes, however, merely showed increases and decreases in the components,
without indicating the possible causes of such differences. We try to go deeper
and analyze in a more detailed manner the variations in the gross income figures.

GROSS PROFIT VARIANCE ANALYSIS

Gross profit is a very important figure in the income statement because it is one of the
factors that determines the final result of operations.

To conduct a meaningful analysis of the variation in gross profit, the actual gross profit
during a given period may be compared with any of the following:

a. the immediately preceding, period's figures or any previous period's figures

selected as the base for comparison
b. the same period's budgeted or standard figures
Changes in gross profit may be attributed to the change in any, or a combination of the
following factors:
1. Selling price(s) of the product(s)
2. Volume or quantity of product(s) sold which, in turn, may be due to change in:
a. number of physical units sold (when the company sells only one product line),
and
b. product mix or sales mix which refers to the composition of the products sold
(this is applicable to companies selling more than one product line
3. Cost of the product sold:
a. For merchandising firms, cost refers to the net purchase cost of the product
b. For manufacturing firms, cost includes the three manufacturing cost elements,
namely, materials, labor and factory overhead.
Importance of Gross Margin Analysis
1. To determine the causes of changes in net sales.
2. To determine the causes of changes in cost of goods sold.
3. To find remedies how to correct the weaknesses in the year’s operating
performance.

Factors affecting changes in net sales, costs of goods sold and gross margin

Single Product Analysis

1. Changes in Net Sales
2. Changes in Cost of Sales
3. Changes in Gross Margin

Changes in Net Sales

2-Way Analysis:
a. Quantity sold (volume analysis)
b. Unit Selling Price (Price analysis)

3 –way analysis:
a. Quantity sold (volume analysis)
b. Unit Selling Price (Price analysis)
Units sold and unit selling price (Volume-price)

Procedures for Analyzing Gross Profit Variations

The procedures involved in analyzing gross profit variations are very similar to those of
analyzing standard cost variances. In this case, however, the actual figures may
be compared with the budgeted data or with figures, for any previous period chosen to
be the base period.

The analysis shows the variances due to the previously mentioned factors: volume and
prices for both the sales and cost of sales figures.
There are, different ways of analyzing gross profit variances. Presented here are the 4-
way, 6-way and 3-way analyses. The formulas for each method are given. In the
following formulas, let us assume that the 20B data represent the actual data, and 20A
data represent the budgeted, standard, previous year or base year data.

4- Way Analysis

Sales Variance:
Sales Price Factor:
20B Sales xx
Less 20B Sales @ 20A sales price xx xx
Sales Volume Factor:
20B Sales @ 20A sales price xx
Less 19A Sales xx xx xx
Cost Variance:
Cost Price Factor:
20B Cost of sales xx
Less 20B Cost of sales @ 20A cost price xx xx
Cost Volume Factor:
20B Cost of sales @ 20A cost price xx
Less 20A Cost of sales xx xx xx
Net Change in Gross Profit xx
===
The above formula maybe further simplified as follows:

4-Way Analysis

Sales Variance:
Price factor = Difference in selling prices x 20B units
Volume or
Quantity factor = Difference in units x 20A selling price
Cost Variance:
Price factor = Difference in cost prices x 20B units
Volume or
Quantity factor = Difference in units x 20A cost price

6-Way analysis

Sales Variance:
Price factor = Difference in selling prices x 20A units
Volume or
Quantity factor = Difference in units x 20A selling price
Price-volume factor = Difference in selling price x Difference in units

Cost Variance:
Price factor = Difference in cost prices x 20A units
 Volume factor = Difference in units x 20A cost price
Price-volume factor = Difference in cost price x Difference in units

The price factor refers to the change in selling or cost prices assuming that there has
been no change in units sold.
The quantity or volume factor refers to the change in the number of units sold assuming
that there has been no change in the selling or cost prices.

The price-volume factor refers to the sales or cost of sales variances due to the
combined effects of the differences in prices and units sold.

3-Way Analysis:

Under the three-way analysis, the gross profit variance is analyzed without showing the
details of the factors that caused the changes in sales and cost of sales. The formulas
are:

Quantity or Volume factor = Difference in units x 20A Gross profit per unit

Price factor = Difference in selling price x 20B units

Cost factor = Difference in cost prices x 20B units

The quantity factor refers to the change in gross profit due to difference in units sold.

The price factor refers to the change in gross profit due to the difference in selling price.

The cost factor refers to the change in gross profit due to the difference in cost price.

Illustrative Example:

Given is the data for JAM Corporation.

20B 20A

Sales volume in units 5,000 8,000

Selling price per unit P 10 P8
Cost per unit 7 6

Let us consider the year 20A in this example as our base year. The gross profit figures
for JAM Corporation for 20B and 20B may be computed as follows:
Increase
20B 20A (Decrease)

Sales volume in units P50,000 P64,000 (P14,000) unfavorable

Cost of sales 35,000 48,000 ( 13,000) favorable.
Gross profit (P15,000 P16,000 (P 1,000) unfavorable
The variances (or differences) between the figures are described either as favorable or
unfavorable. Naturally, a decrease in sales is unfavorable and a decrease in Cost
is favorable. A decrease in gross profit must be described as unfavorable. In the
analysis of the gross profit variances, each variance must likewise be properly
described. A variance without a description is meaningless.

The analysis of gross profit variances for JAM Corporation follows. They variances are
described as favorable (F) or unfavorable. Since this is an illustrative example, let us
use all the different methods of analysis discussed above. In practice, however, the
analyst may simply choose and use any of the methods presented.

4-Way Analysis:

Sales Variance:
Price factor:
20B sales P 50,000
20B units @ 20A selling price
(5,000 x P 8) 40,000 P 10,000 F
Quantity or volume factor:
20B units @ 20A selling price P 40,000
20A sales 64,000 24,000 U P 14,000 U
Cost of Sales Variance:
Price factor:
20B cost of sales P 35,000
20B units @ 20A cost price
(5,000 X 6) 30,000 P 5,000 U
Quantity or volume factor:
20B units @ 20A cost price P 30,000
20A Cost of sales 48,000 18,000 F P 13,000 F
Net Gross Profit Variance P 1,000 U

To facilitate the analysis and simplify computations, the gross profit data for JAM
Corporation may be organized in a manner given below:

Sales
Units Selling price Total
20B 5,000 P 10 P 50,000
20A 8,000 8 64 000
Difference 3 000 U P 2F P14,000 U

Cost of Sales

Units Selling price Total

20B 5,000 P 7 P 35,000
20A 8,000 6 48,000
Difference 3 000 F P 1U P 13,000 F

Note that the difference in units of 3,000 in the sales tabulation is described as
unfavorable (U) because it will bring about a decrease in total sales. In the cost of sales
tabulation, however, this difference is described as favorable because a decrease in
units will cause a decrease in cost of sales.

Let us now illustrate the other methods of analysis using the data presented in the
foregoing tabulations.

4-Way Analysis (Alternative Computation):

Sales Variances
Price factor = Diff.in selling prices x 20B units
= P2 F x 5,000 = P 10,000 F
Quantity factor = Diff. in units x 20A selling price
= 3,000u x P8 = 24,000 U P14,000 U
Cost of Sales Variance:
Price factor = Diff. in cost prices x 20B units
= P 1 u x 5,000 = P 5,000 u
Quantity factor = Diff. in units x 20A cost price
= 3,000 F x P6 = P18,000 F P 13,000 F
Net Gross Profit Variance = P 1,000 U
========

6-Way Analysis:

Sales Variance:
Price factor = Diff. in selling prices x 20A units
= P2 F x 8,000 = P16,000 F
Quantity factor = Diff. in units x 20A selling price
= 3,000 u x P8 = 24,000 U
Price-Volume
factor = Diff. in units x Diff. selling prices
= 3,000 u x P2 = 6 000 U P14,000 U
Cost of Sales Variance:
Price factor = Diff. in cost prices x 20A units
= P 1 U x 8,000 = P 8,000 U
Quantity factor = Diff. in units x 20A cost price
= 3,000 F x P6 = 18,000 F
Price Volume factor = Diff. in units x Diff. in cost prices
= 3,000 F x P 1 U = 3,000 F 13,000 F
Net Cross Profit Variance P 1,000 U
=======

3-Way Analysis:
Quantity factor = Diff. in units x 20A gross profit per unit
= 3,000 x [ 8-6] = P 6,000 U
Price factor = Diff. in selling prices x 20B units
= P2 F x 5,000 = P10,000 U
Cost factor = Diff. in cost prices x 20B units
= P 1 u x 5,000 = 5,000 U

Net Gross Profit Variance P 1,000 U

GROSS PROFIT VARIANCE ANALYSIS FOR TWO OR MORE PRODUCTS

When two or more products of different gross profit figures are being sold, the 6-way
analysis may be used. The sales price, sales volume, cost price and cost volume
variances are first computed using the approach similar to the one used for 4-way
analysis in the foregoing discussions. Then, the sales volume and cost
volume variances are analyzed further, which results in the computation of a sales mix
variance and final sales volume variance. The formulas for these last two variances are
as follows:

Sales Mix Variance:

20B units @ 20A sales price xx
Less: 20B units @ 20A cost prices xx
Difference xx
Less: 20B units @ 20A average gross profit xx
Sales Mix Variance xx
===

Final Sales Volume Variance:

20B units @ 20A average gross profit xx
Less: 20A gross profit xx
Final Sales Volume Variance xx
===

ILLUSTRATIVE EXAMPLE

Let us use the following data for White Jam Corporation to illustrate analysis of gross
profit variances when two or more products are sold:

20B 20A (base year)

Products
Prod J Prod A Prod. M Prod J Prod A Prod. M
Sales in volume
in units 400 350 1,000 500 200 1,000
Selling price
per unit P4 P5 P3 P 4.20 P 4.50 P 2.80
Cost per unit P 1.60 2 P 1.20 P1.68 P 1.80 P 1.12

The amounts of gross profit earned by White Jam Corporation may be computed as
follows:

Increase
20B 20A (Decrease)
Sales:
Product J (400 x P4) P 1,600 (500 x P4.20) P2,100
A (350 x P5) 1,750 (200 x P4.50) 900
M (1,000x P3) 3,000 (1,000xP2.80) 2,800
Total Sales P6 350 P 5,800 P 550 F

Less Cost of Sales:

Product J (400 x P 1.60) P 640 (500 x P1.68) P 840
A (350 x P2) 700 (200 x P4.50) 360
M (1,000x P1.20) 1,200 (1,000xP2.80) 2,800
Total Cost of Sales P 2,540 P 2,320 P 220 F

Gross Profit P 3,810 P 3,480 P 330 F

====== ====== ======

Let us now conduct an analysis to see why there is such a favorable variance of P 330
in gross profit.

Sales Variance:
Price factor
20B sales P6,350
20B units @ 20A selling prices:
Product J ( 400 x P4.20) P 1,680
Product A (350 x P4.50) 1,575
Product M (1,000 x P2.80) 2,800 6,055 P 295 F
Quantity factor:
20B units 20A selling prices P6,055
20A sales 5,800 255 F P 550F
Cost of Sales Variance:
Price factor:
20B cost of sales P2,540
20B units @ 20A cost prices:
Product J (400 x P1.68) P 672
Product A (350 x P1.80) 630
Product M (1,000x P1.12) 1,120 2,422 P 118 U

Quantity factor:
20B units @ 20A cost prices P 2,422
20A cost of sales 2,320 102 U 220 U
Net Gross Profit Variance P 330 F
=======
Let us summarize the results of the preceding computations to account for the favorable
difference of P 330 in gross profit:

Favorable sales price variance P 295

Favorable net volume variance:
Sales volume variance P 255 F
Cost volume variance 102 U 153
Total favorable variances P 448
Less: Unfavorable cost price variance 118
Favorable net gross profit variance P330
====
The net favorable volume variance of P 153 is actually a combination of the sales and
cost volume variances. Since we know that the total sales volume involves three
different products, we have to analyze the net volume variance further to see the effect
of the sales mix (or product mix) and final sales volume variances. Let us use the
formulas presented.

Sales Mix Variance:

20B units @ 20A selling, prices P 6,055
Less 20B units @ 20A cost prices 2,422
Difference P 3,633
Less 20B units @ 20A average gross profit per unit
(1,750*x P2.047**) P 3,582.25 50.75 F
Final Sales Volume Variance:
20B units @ 1989 average gross profit P3,582.25
Less 20A gross profit 3,480.00 102.25 F
P153.00 F
=======
*Total number of units sold in 20B:
Product J 400
A 350
M 1,000
Total 1,750
=====
20𝐴 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
**Average 20A gross profit per unit = 𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑖𝑛 20𝐴

𝑃3,480
= 1,700

= P 2.047
=======

Alternative Solution:

The sales mix and final sales volume variances may be computed in another manner
as shown below:

Sales Mix Variances:

Product 20B units 20B units Difference 20A gross Sales Mix
@ 20A in sales profit per Variance
sales Mix mix unit
ratio
J 400 514.50 114.50U P 2.52 P 288.54
U
A 350 206.50 143.50F 2.70 387.45F
M 1,000 1029 29U 1.68 48.72U
Total 1,750 1,750 - P 50.19F
Rounding 0.56
difference
 Sales Mix P 50.75 F
variance ========

*20A Sales Mix ratio:

Ratio
Product J 500 5/17 29.4%
A 200 2/17 11.8
M 1,000 10/17 58.8
Total 1,700 100%

** The difference in sales mix is described as unfavorable when the actual number of
units sold is less than the number of units that should have been sold if the base year's
sale mix ratio was maintained.

+ 20A Gross profit per unit = Selling price – Cost per unit

J = P4.20 - P1.68 = P2.52

======

A = P4.50 - P1.80 = P2.70

======

M = P2.80 – P 1.12 = P 1.68

======

Final Sales Volume Variance

20B total units sold 1,750
Less 20A total units sold 1,700
Difference in the number of units sold 50 F
x 20A average gross profit per unit P 2.047
Total P 102.35 F
Rounding difference 0.10

Final sales volume variance P 102.25 F

The foregoing alternative computations seem to be more complicated than the first set
of formulas presented. Nevertheless, these computations clearly show the logic
in the variance being computed. The differences in sales mix and sale volume are more
conspicuously presented here than in the original formulas.

Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, E and Houston, J. (2015). Fundamentals of financial management. 13th
edition, Cengage Learning.

Mc Menamin, J. Financial management: an introduction- Tutor’s guide. Routledge,

11 New Fetter Lane, London (2005 ed.).