3 Causes of Errors in Monthly Gross Profit..and How to Fix Them
“Variability has the potential to create confusion.” -Steven Redhead
A distributor friend called me recently with a concern about his gross profit. He was seeing a lot of fluctuation in monthly gross profit percentage. Some months it was too low, 22%, other months it was too high, 26%. My friend asked what might be causing these highs and lows and how he could fix it.
Variation in monthly gross profit can cause confusion, uncertainty and a lack of faith in the accuracy of the numbers. More importantly, it may be a symptom of a big problem in your financial system that needs to be fixed.
In this article, I will share with you the same ideas and action steps that I gave to my friend to solve his gross profit problem.
If you are seeing fluctuations in your monthly gross profit, one of these causes might be the reason.
3 Causes of Variation in Monthly Distributor Gross Profit
- Inventory received, but the purchase expense not recorded
- Inventory value does not match actual costs
- Empty barrels and pallets are returned, but credit not recorded
Cause #1: Inventory Received but Purchase Expense Not Recorded
Very often, inventory is received into the warehouse but the related invoice has not arrived in the mail. The accounting transaction records the value of the inventory but the purchase expense isn’t recorded.
In this case, gross profit for the month will be overstated.
This can happen at anytime throughout the month, but it causes the biggest variance when it occurs at month end. For example, the inventory is received and recorded in January, but the invoice and purchase expense is recorded in February.
In this circumstance, the gross profit will be overstated for January and understated for February.
Over time, these variations sort themselves out, but when you look at month to month gross profit there are a lot of inconsistencies.
To determine if you have this problem in your company, do a test of inventory receipts and match them up to your supplier invoices. Test when the inventory receipts and related purchase expenses are recorded. If they do not occur in the same month, your gross profit will be incorrect.
Fortunately, this problem is easy to identify and easy to fix.
Many accounting systems have the capability to create an open purchase order report. This report shows whether inventory was received but not matched up with an invoice. If the invoice doesn’t arrive on time, the expense is still recorded. The asset received (inventory) is matched up in the same month with the related expense (purchase).
To check for this potential problem in your business, have your finance team test the idea above to make sure you are properly matching up the inventory receipt with the related purchase expense.
Cause #2: Inventory Value is Different from Actual Costs
Inventory can be valued in a number of different ways. One such valuation method is to use Standard Costs. A standard cost involves using the expected FOB and freight costs for the products.This is a simple, effective method to valuing inventory.
The potential problem with using standard costs is that costs change. A supplier may increase it’s price or the freight cost to get product to your warehouse may increase significantly. Recall when gas prices went through the roof and every freight carrier was charging excessive surcharges.
When actual costs change, and standard costs are not updated, you will get variations in monthly gross profit percentages.
To see if you have this problem in your distribution business, have your finance person test your actual costs compared to your standard product costs.
This test is done by looking at your top five or ten selling SKUs and pulling the related supplier invoices. Check the inventory value of the product (the FOB and freight) and compare it to the most recent supplier invoice. If there are differences, adjust the standard cost of your inventory.
This process will ensure that your inventory value is synced up with the purchase expense. And it will smooth out fluctuations in monthly gross profit percentage.
Cause #3: Empty Kegs Returned but Credit Not Recorded
Big breweries charge distributors a deposit for kegs and pallets. The value of the deposits, say $30 per keg and $15 per pallet, is recorded in the inventory value.
When empty kegs and pallets are received by the distributor from the retailer, the deposit value is recorded in inventory. When kegs and pallets are returned to the supplier they are deducted from inventory and a credit will be due to the distributor.
Fluctuations in gross profit can occur when the kegs/pallets are sent back (and value deducted from inventory) but the corresponding credit due back from the brewery is not recorded.
This can happen any time during the month, but usually occurs at month end. A trailer of kegs is sent back to the brewery, the inventory of empty kegs is deducted from inventory, but the credit due from the brewery isn’t recorded.
To see if you have this flaw in your accounting system, have your finance team test the timing of when kegs/pallets are removed from inventory and when the credit from the brewery is recorded. If the deduction occurs in one month and the credit occurs in another, you’ll have an issue with gross profit.
Wrap Up + Action Items
Monthly gross profit variances cause frustration and confusion for owners and managers in your beer business. It is hard to have faith in the financial statements when the gross profit changes so much from month to month. More importantly, these fluctuations may be a symptom of a bigger problem in your financial system.
To correct variability in your distributor gross profit, test the common problems noted in this article.
- Inventory received, but the purchase expense not recorded
- Inventory value does not match actual costs
- Empty barrels and pallets are returned, but credit not recorded
The tests are quick and easy. The benefits to your company and financial reporting are long lasting. Fix your gross profit errors and restore confidence in your financial statements today.
