This post contains three operating performance measurements focus on the margins derived at when certain types of expenses are included. Each measurement description includes an overview, notes on how to derive the calculation, and how it is used in an example.
The most highly recommended one is the operating profit percentage, especially when tracked on a trend line, since it shows operating results before any special adjustments are added that might otherwise cloud the picture of a company’s truly underlying performance.
Gross Profit Percentage
This measurement reveals the profit left over from operations after all variable costs have been subtracted from revenues. In essence, it shows the efficiency of the production process in relation to the prices and unit volumes at which products are sold. There are two ways to measure the gross margin.
The most common approach is to add together the costs of overhead, direct materials, and direct labor, subtract them from revenue, and then divide the result by revenue. This approach takes into account all costs that can be reasonably associated with the production process. The formula is:
[Revenue – (Overhead + Direct Materials + Direct Labor)] / Revenue
Note: The trouble with this approach is that many of the production costs are not truly variable.
Under a much more strictly defined view of variable costs, only direct materials should be included in the formula, since this is the only cost that truly changes in lockstep with changes in revenue. All other production costs are then shifted into other operational and administrative costs, which typically yields a very high gross margin percentage. The formula is:
(Revenue – Direct Materials) / Revenue
The ABC Tile Company bases its sales quoting system on the gross margin assigned to its products—prices quoted must have a gross margin of at least 25% in order to cover administrative costs and create a modest profit.
Recently, the XYZ Tile Company has been taking business away from the ABC Tile Company through more aggressive pricing. Investigation of its competitor’s quoting practices reveals that it uses an alternative gross margin model that uses only direct material costs as a deduction from revenues. This means that its competitor is always in a position to offer lower prices, since it does not incorporate direct labor and overhead costs into its pricing model.
The XYZ Tile Company is in danger of quoting excessively low prices if it continues to use its gross margin model, so it focuses on how prospective sales will impact its bottleneck operation, which is the tile kiln.
If a prospective sale requires a great deal of kiln time, then it is charged a much higher price than other quotes that do not use as much of this valuable resource. As a result of this survey, the ABC Tile Company realizes that its competitor has a more precise and aggressive quoting model that will likely result in more lost sales for ABC Tile in the future.
Operating Profit Percentage
The operating profit percentage reveals the return from standard operations, excluding the impact of extraordinary items and other comprehensive income. Use of this percentage reveals the extent to which a company is earning a profit from standard operations, as opposed to resorting to asset sales or unique transactions to post a profit.
Formulation: subtract the cost of goods sold, as well as all sales, general, and administrative expenses, from sales.
In order to obtain a percentage that is strictly related to operational results, be sure to exclude interest income and expense from the calculation, since these items are related to a company’s financing decisions rather than its operational characteristics. Expense totals used in the ratio should exclude all extraordinary transactions, as well as asset dispositions, since they do not relate to continuing operations. The formula is:
[Sales – (Cost of Goods Sold + Sales, General & Administrative Expenses)] / Sales
The Lie Dharma, a chocolate company has a loan with the local bank whose covenants include the stipulation that the loan will be immediately callable if the company’s operating profit percentage drops below zero.
In the current month, it will incur an operating loss of $15,000, which will allow the bank to call its loan. The calculation it is using to derive the operating loss is shown below:
Cost of goods sold –571,000
Gross margin 857,000
Operating costs –849,000
Interest expense –23,000
Operating profit/loss $15,000
Operating profit percentage –1%
Since there is no specification in the loan agreement of the operating loss calculation, the Controller defines it as excluding financing activities, removes the interest expense from the calculation, and achieves an operating profit of $8,000. To be ethically correct, the Controller also specifies the exact contents of the calculation in her next report to the bank.
Net Profit Percentage
This percentage is used to determine the proportion of income derived from all operating, financing, and other activities that an entity has engaged in during an accounting period.
It is the one most commonly used as a benchmark for determining a company’s performance, even though it does not necessarily reflect a company’s cash flows, which may be negative even when net profits are reported. The formula is to divide net income by revenue.
Net Income / Revenue
If this percentage is being tracked on a trend line, it may be useful to eliminate from the calculation any extraordinary income items, such as losses from disasters, since they do not yield comparable period-to-period information.
The Modern Care Salon is a franchise operation that pays for the initial fixed assets required by each franchisee. This involves an investment of about $200,000 per hair salon.
The management team is determined to grow the operation as fast as possible while still reporting healthy profits. To do so, it sets the capitalization limit very low, at just $250, so that nearly everything it purchases is capitalized.
Because it uses a ten-year depreciation period for all fixed assets, this results in the recognition of costs over many future periods that would normally be recognized at once if a higher capitalization limit were used.
Its operating results for a typical store are shown below:
Assets < $1,000 42,000
Net income $15,000
Net income percentage 4%
The key line item in the above figure is the assets costing less than $1,000; if the company had set a higher capitalization limit, these costs would have been recognized as expenses at once, which would have yielded a loss on operations of $27,000 per store.
As a result, the company’s accounting policy is creating false profits. When combined with the high initial setup cost of each store, it is apparent that this seemingly healthy franchise operation is actually burning through its cash reserves at a prodigious rate.