1.3 Ratios With More Than Two Quantities
In some business situations, it is desirable to examine the relative sizes of a number of quantities. In such cases, ratios of the quantities are used.
Consider, for example, the expenses of a merchandising company. These expenses can be usefully broken down into two major components:
- the cost of the goods sold (COGS)
- all other expenses, called operating expenses.
When analyzing merchandising companies, it is customary to first deduct the cost of goods sold from sales revenue, and to call the result the gross profit.
[latex]Sales - COGS = Gross \; Profit[/latex]
Operating expenses are then deducted from the gross profit to get net profit.
SALES
– COGS
GROSS PROFIT
– OPERATING EXPENSES
NET PROFIT
All of these quantities are commonly compared with the sales revenue as the base.
Example 1.3.1
Suppose that in our opening example, in which the company had sales of $32,000 in a period, the cost of these goods was $20,000 and operating expenses were $4,000. You would arrange the analysis as follows:
| $ | % Sales | |
| Sales | $32,000 | 100.00 |
| – COGS | 20,000 | 62.5 |
| Gross Profit | 12,000 | 37.5 |
| – Operating Expenses | 4,000 | 12.5 |
| Net Profit | 8,000 | 25.0 |
This has the format of a (very) simple Income Statement.
When gross profit is compared with sales it is called percent gross margin. Net profit compared with sales is called percent net margin.
Key Takeaways
Suppose now that a similar company was expected to perform with the same ratios but to have sales of $50,000 in a period. Then each of the other entries could be calculated by using the above ratios. For example:
[latex]\frac{COGS}{Sales} = \frac{COGS}{\$50,000}=\frac{62.5}{100}= 0.625[/latex]
So
[latex]COGS = Sales \times 0.625 =\$ 50,000 \times 0.625 = \$ 31,250[/latex]
Notice that while the ratio was stated as a percent, it was necessary to replace it with the decimal equivalent in order to do the calculations. You should check that the other quantities come out, as in the following table:
| % Sales | ||
| Sales | $50,000 | 100.0 |
| COGS | 31,250 | 62.5 |
| Gross Profit | 18,750 | 37.5 |
| Operating Expenses | 6,250 | 12.5 |
| Net Profit | 12,500 | 25.0 |
Another use of ratios is to allocate resources according to some measure of need or performance in an organization. For example, bonuses may be given as a percent of sales; budgeted expenses may be a percent of the previous year’s expenses.
Knowledge Check 1.3
A merchandising company finds that its COGS is 65% of sales and its monthly operating expenses are $14,000.
What would be the COGS and the gross and net profits on sales of $90,000 in a month?
What would be its percent gross margin and percent net margin?
Your Own Notes
- Are there any notes you want to take from this section? Is there anything you’d like to copy and paste below?
- These notes are for you only (they will not be stored anywhere)
- Make sure to download them at the end to use as a reference
Total Variable expenses, or all the costs that go into making your item.
Fixed Costs
