Analysis of Changes in Income

The purpose of preparing a financial statement is not only to know the net income or losses of concern for the current year, but also to know the change in net income or losses of a firm in comparisons to the preceding years.

There are two types of financial statements, which reflect two types of profits i.e. trading account shows the gross profit and Profit & Loss accounts shows the net profit of the concern for a specific accounting period. Under this chapter, we will discuss the reasons for changes in Gross Profit Ratio.

Gross Profit Ratio (GPR)

Gross profit means, excess of sales over cost of goods sold. This ratio also indicates the losses due to damage or mismanagement. More the ratio is high more it is good for a financial health of a concern. Chances of higher net income are more in an organization where ratio of gross profit is high (formula is given below) −

$$\normalsize Gross\:Profit\:Ratio = \frac{Gross\:Profit}{Net\:Sales}$$

Higher gross profit provides leverage to the management to meet their indirect expenses and to spare net income for the distribution of profit and to increase the reserves.

Gross Profit Margin

When Gross profit margin is presented in percentage, it is called as Gross profit margin (formula is given below) −

$$\normalsize Gross\:Profit\:Margin = \frac{Gross\:Profit}{Net\:Sales} \times 100$$

Chances of Increase in GPR may be due to following Reasons −

• Without increase in corresponding costs, if there is an increase in selling price.

• Without decrease in selling price, if there is decrease in cost of production of products.

• There may be equal decrease or increase in selling price and cost of production without affecting gross profit of the current year.

• There may be chances that the valuations of closing stocks are done with higher price.

• It is also possible that the opening stock of a concern is valued at very lower rate.

• There is a possibility that given sales are inclusive of consignment sale due to any mistake or otherwise.

• Omission of purchase invoices in the books of accounts may also be one of the reasons for higher gross profit.

Chances of Decrease in GPR may be due to following Reasons −

• If cost price remains same, but decrease in selling price.
• Sale price remains same, but increase in cost of production.
• Personal used goods debited to purchase account.
• Closing stock may be valued at very low price.
• Opening stock may be valued at very high price.
• Any omission or mistake while valuation of closing stock.

It is necessary for survival and progress of any business to keep its margin of gross profit high as much as possible to enable it to cover its operative expenses as well as indirect expenses.

Analysis of Gross Profit

Analysis of changes in gross profit is the first step in determination of a net income. Change of gross profit in current year may be due to the following reasons −

• Change in sale amount may be due to following three reasons −
  • Change in selling price.
  • Change in quantity sold without change in sale price.
  • Change in sale price as well as quantity of goods sold.
• Change in cost of goods sold may be due to following reasons −
  • Change in cost of production.
  • Change quantity of goods sold.
  • Change in quantity as well as cost of goods sold.

Example

Make an analysis of changes from the information given below −

Solution

Increase in sales amount due to price −

Increase in price per unit × Number of unit sold in current year

= 10 × 6000 = 60,000

Increase in sales amount due to Quantity −

Increase in number of unit sold × price of last year

= 1,000 × 70 = 70,000

Combined effect of change in quantity and price (A+B)

= 1, 30,000