Gross Profit Analysis
— Comparing two or more enterprises: which enterprises contribute the most to covering the overheads of the business?The English economist, David Wallace, developed gross profit analysis at Cambridge University. It is sometimes also known as gross margin analysis. Gross Profit is:
Income from an enterprise less the expenses directly incurred in earning that income.
This is a technique that separates ‘fixed’ costs (those costs you will encounter regardless of what you produce—or how much of it you produce) from the costs directly related to production, which are known as ‘variable’ costs.
Fixed costs are sometimes called overheads of the business, and include items such as rates, administration costs, wages and drawings, phone, electricity etc. They do not rise or fall because production has risen or fallen.
Variable costs are sometimes also referred to as ‘direct’ costs, as they have a direct relationship with production. Variable or Direct costs rise pro-rata as units of production increase. In an agricultural setting, the decision to grow an extra hectare of crop means the business will incur an extra hectare’s worth of cost for seed, fertiliser, chemicals etc. Adding an additional animal into a herd or flock not only leads to an additional unit of income, but to an additional unit of expenses as well.
In an industrial setting, a factory that produces an extra widget of production incurs an extra widget’s worth of raw materials cost, and hopefully, an additional widget’s worth of sales.
In each case the difference between the income received for a unit of production and the variable costs incurred making the unit of production is the Gross Profit.
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Why you need high gross profit enterprisesIn the long term both the ‘overheads’ of the business and the net profit due to its owners can only be paid if there is adequate gross profit. If there is not sufficient gross profit the business runs at a loss and is economically unsustainable. The following Table shows this graphically.
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