Overview

Cost of Sales and the Different Profit Margins

Cost of sales has a big impact on the profits a company generates. Profit margins are revisited from the perspective of how three different expense components
impact these margins. This recognizes that it's not enough to generate sales to earn a profit. Good cost management can improve profits.

Upon completion of this lesson, candidates should be able to:

Analyze cost of sales by calculating and interpreting the gross profit margin (2.A.3.g).

Distinguish between gross profit margin, operating profit margin, and net profit margin and analyze the effects of changes in the components of each (2.A.3.h).

Define and perform a variation analysis (percentage change over time) (2.A.3.i).
Study Guide
Cost of Sales and the Different Profit Margins

I. Let's look at manufacturing company Chicago Cereal Company's income statement. This analysis can also be used for a merchandising company. The
manufacturer will “purchase” the materials used to make the products they sell. The merchandiser will “purchase” the products they sell.

Kimmel, Paul D. Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, 2015.
The percentages have already been calculated for us on this statement. As a reminder, this vertical analysis uses Net Sales as the base amount.
A. Gross Margin = Gross Profit ÷ Net Sales = $5,179 ÷ $11,776 = 44.0%
1. Gross Margin measures the amount of each sales dollar available to cover operating expenses, including selling and administrative expenses, other
expenses, and income tax expense. Chicago Cereal has $0.44 of every sales dollar available.
2. A company operating in a competitive market will not be able to set the selling price. In this situation, the only way the company can improve the
gross margin is to manage its manufacturing costs, including purchasing costs. They will be highly motivated to reduce the cost of inventory.
3. When the company has flexibility in setting the selling price, it is able to cover cost increases in direct materials, direct labor, and manufacturing
overhead or merchandise inventory included in cost of sales. This company may not be as motivated to lower these costs.
B. Operating Margin = Income from Operations ÷ Net Sales = $1,868 ÷ $11,776 = 15.9%
1. Operating Margin measures the amount of each sales dollar available to cover interest expense, other expenses, and income tax expense. Chicago
Cereal has $0.159 of every sales dollar available.
2. Operating Margin is a key metric for service firms. The reason is that service firms do not have cost of sales, and therefore have no Gross Margin.
The primary expense incurred to provide their services are professional service fees. The service firm will look to reduce the cost of professional
services as well as operating expenses.
C. Profit Margin = Net Income ÷ Net Sales = $1,103 ÷ $11,776 = 9.4%
1. Profit Margin measures the amount of each sales dollar earned for the common stockholders of the company. Chicago Cereal earned $0.094 of
every sales dollar for its stockholders.
D. Each margin has more meaning when it is compared to the prior period, a competitor's margins, or an industry average. Managing/reducing costs is an
important way to increase profit margins. Cost reductions should not be done if it means the quality standards are not met.
II. Each ratio is determined by the expense component used to calculate it. The following chart identifies each cost category and its impact on each ratio.

Understanding the income statement, and how the different margins are determined, is extremely important for both the managers of the company and the
external users of the statement. The managers use this information to focus on costs that may need to be reduced. The external users of this information want
to determine how profitable the company is at each level.

Summary
This revisit to the three profit margins shown on the income statement focuses more on the impact that the different costs/expenses have on them. The
calculations should be very familiar to you by now. Cost of goods sold is extremely important because this amount impacts gross margin, operating margin, as
well as profit margin. Make sure to understand the impact each cost/expense item has on the different levels of income/margin.
Flashcards
Cost of Sales and the Different Profit Margins

1
FC.cost.sales.FC001_1709

How is Gross Margin calculated and what does it measure?

Gross Margin = Gross Profit ÷ Net Sales

Gross Margin measures the amount of each sales dollar available to

cover operating expenses, including selling and administrative
expenses, other expenses, and income tax expense.

2
FC.cost.sales.FC002_1709

How is Operating Margin calculated and what does it measure?

Operating Margin = Income from Operations ÷ Net Sales

Operating Margin measures the amount of each sales dollar available

to cover interest expense, other expenses, and income tax expense.

3
FC.cost.sales.FC003_1709

How is Profit Margin calculated and what does it measure?

Profit Margin = Net Income ÷ Net Sales

Profit Margin measures the amount of each sales dollar earned for the
common stockholders of the company.
Notes
Cost of Sales and the Different Profit Margins

You haven’t made any notes or highlights yet.