Gross Profit in DetailThe Gross Profit Analysis testing guideline is:
(Comparing two or more enterprises):
Which enterprises contribute the most to covering the overheads of the business?Almost always used in the Financial Planning process. Critical in that process.
Gross profit analysis is one of the key elements of holistic financial planning. It is a way to compare ‘Apples with apples’ and ‘Apples against pears’.
Below are the Income and the Variable expenses relating to two different crops a farmer is considering growing this season. The variable expenses are those expenses that will be incurred if a hectare of crop is planted (for example seed, fertiliser, contracting costs etc), but no expense is incurred if the decision was to not grow the crop.
Although Enterprise A has a much higher turnover ($300 per hectare as against $250 per hectare for B), its variable costs (such as seed, fertilisers, chemicals etc) are also much higher.
Enterprise B has a higher Gross Profit than A by $25 per hectare.
You should only engage in High Gross Profit enterprises
It is always important to engage in enterprises that have high gross profit because all the overheads of the business, including the all-important net profit, depend on first achieving high gross profit. If you cannot find a way to reorganise an enterprise, it is often better to drop an enterprise out of your business that has low gross profit.
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Principles of Gross Profit Analysis
The costs included in a Gross Profit Analysis are ‘Enterprise specific’. David Wallace, Professor of Economics at Cambridge University, and developer of the Gross Profit concept, repeatedly stressed the importance of not considering any factors other than the two critical components of Gross Profit—Income and Variable costs. Note: other factors are considered later on in the planning process—but not at this stage. The two important components are:
The two components: Income and Variable Expenses.
Income is simply yield per unit of production (hectare, head or whatever is appropriate) times price received per unit of yield. Eg Tonnes per hectare x price per tonne = Income per Ha.
Variable expenses are the expenses incurred in producing a unit of production. Eg Seed, fertiliser, chemicals etc, per hectare (acre) - in a cropping situation and dips, drenches, vaccines.licks etc, per head - in a livestock situation.
Overhead costs are not included
Overhead costs are costs that you incur regardless of what enterprises you run. They do not rise or fall if you add another unit of production (cow/ewe/hectare/acre etc), or drop out a unit of production. Typically they include things like land ownership costs, phone, power, gas, wages, owners drawings, etc.
Gross Profit and Gross Margin are the same animal
On occasions you may see reference to the words, “Gross Margin”. Wallace originally used the words ‘Gross Profit’ to describe his concept. In America it was described by some as ‘gross margin’, and so long as it is used to describe only ‘Income minus Variable Expenses’ it is the same thing.
When managing holistically, for two reasons we like to use the terminology, Gross Profit: first, because it honours Wallace; and second, it avoids confusion between this subject and one of the other Testing Guidelines, ‘Marginal Reaction’.
Use Poor - Average - Good
When undertaking a your gross profit analysis it is very important to look at each enterprise from a couple of perspectives. It is very wise to consider what could happen to your business if something goes wrong with the enterprise—for instance, if yields are not as planned, or prices collapse for reasons outside your control.
By considering an enterprise for outcomes under Good, Average and Poor scenarios you are more likely to know the risks you are taking and you are pre-prepared if a problem actually strikes.
Change the things you have least control over
As the image below show, you should find and vary the Income item you have the least control over (in this case ‘Price per kg’ has been selected), and also the Expense item you have the least control over (in this case it is the ‘Replacement cost per Kg of store steers’
Compare against the most limiting factor
When preparing a gross profit analysis, you should select the item that is most limiting. In a cropping program the usual most limiting factor is the hectares of land available to plant a crop into. That limitation might be a physical limitation, or even a limitation imposed by maintaining a suitable crop rotation program. In some cases the limitation in area might relate to the available resources required to till the ground—how many hectares the horse or oxen can work in a season.
In a livestock enterprise it is quite likely to be the carrying capacity of the land: measure this in whatever is relevant for you - DSE (Australia), SAU, LSU, NZ Stock Units etc. Click below to download the Tables.
The advantage of using a standard unit of your choice is that the real demands of animals are considered, and as a result, the real return per unit of feed consumed can be calculated. For example, a 450 kg cow producing a calf has a significantly higher annual demand for feed than a steer carried for a year who might range from 300 kgs at the start through to 600 kgs at slaughter (average 450 kgs over his time in the ‘steer fattening’ enterprise).
Another common limiting factor is the money available to invest in an enterprise. In this case the gross profit is divided by the money invested in the enterprise to give ‘Gross Profit per dollar invested’.
In non-agricultural businesses the limiting factor might be shelf space or floor area.
A word on Cost Accounting
Cost accounting is widely used in industrial and commercial sectors, even though it is gradually losing favour for a number of reasons. Essentially, it conflicts with any attempt at managing holistically.
In agriculture cost accounting can be devastating. When used, it lacks any way to factor in the social and biological consequences of a decision made on economic decisions grounds. Furthermore, cost accounting seeks to apportion overhead costs to enterprises, conflicting completely with the purpose of Gross Profit analysis.
One result of the cost accounting mentality is that people tend to focus their decisions on local optima rather than the effect of an action or decision on the business as a whole.
For instance, many people have abandoned formerly integrated enterprises that included livestock and cropping. They have become convinced that fertility can be maintained by chemical processes rather than biological processes, but over time have discovered that biodiversity has been dropping, and costs of production have been rising, often faster than increases in the price received for the commodities they produce.
The risks of Gross Profit Analysis
The two big risks are:
- Even if an enterprise has a high Gross Profit, that may still not be enough to cover the overheads of the business. You must be careful to fully think through the entire business. This is covered more fully in Section 7.
- Sometimes an enterprise that has high Gross Profit is rejected for other reasons: either it is biologically unsound when compared to your holisticgoal, or it is socially unsound in some way. Maybe it demands work hours that are inappropriate in terms of your holisticgoal, which might have words in it about family time, leisure time or ample opportunities for personal development, and so on.