International Door & Operator Industry

NOV-DEC 2013

Garage door industry magazine for garage door dealers, garage door manufacturers, garage door distributors, garage door installers, loading docks, garage door operators and openers, gates, and tools for the door industry.

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MANAGEMENT (continued from page 44) Some will argue that including collected taxes in sales is OK as long as the tax is subsequently deducted in COGS. Not so. Consider the simplifed data in Exhibit 2: Calculating Gross Margin All of the preceding discussion indicates that the fundamental equation is Sales minus Cost of Goods Sold equals Gross Margin. That appears to be so ridiculously simple that you are tempted to ask why we are engaging an article to discuss the subject. However, both sales and COGS can be (and usually are) misinterpreted - so much so that the calculated GM may be misstated by one-sixth or more! Consider the example in Exhibit 1: Exhibit 1 Up&Down; Garage Doors, Inc. Annual Income Statement % of Sales Sales 3,623,000 100.0% Materials 1,639,000 45.2% Labor 477,000 13.2% COGS 2,116,000 58.4% GM 1,507,000 41.6% Exhibit 2 Sales Tax Impact on Gross Margin Margin Derived INCORRECTLY Margin Derived Correctly Sales Sales tax (7.0%) Gross Sales Gross Revenue $1,070,000 - Sales tax (7.0%) (70,000) Net Sales 1,000,000 100.0% Materials & Labor Collected Sales Tax Gross COGS 600,000 70,000 670,000 Gross Margin 400,000 The example displays the "above the line" annual 2012 internally prepared detail for an actual door dealership. The numbers have been rounded for sake of simplicity, and, of course, the identity of the frm is disguised. Unfortunately, the sales are over-stated by about 6.6%, and COGS is understated by nearly 6.0%, which results in a rather dramatic 31.0% overstatement of Gross Margin. (Each variance is stated as a percentage of the incorrect numbers displayed above) There are three serious, but typical faws in the calculation of the Up&Down; gross margin: 1) Gross sales (or total revenues) have not been adjusted to eliminate funds that are collected, but which are not part of the frm's usable revenue stream (e.g., sales taxes), 2) Materials costs do not refect inventory changes, and 3) Labor wages have not been fully burdened with various employee benefts. Let's hasten to point-out that in most cases of gross margin misstatement, a nearly correct earnings number is ultimately derived because the items incorrectly included in sales, or omitted from costs are recognized elsewhere in the accounting process. But calculating an almost correct bottom line is not the point. Management must know how much margin is actually being generated, and understand the logic of the calculation, in order to make correct pricing decisions, set logical product line strategies and affect viable business planning. Getting to Net Sales Most businesses must charge and collect sales and/or use taxes on all or a portion of their revenues. Such taxes are levied by states, municipalities and various taxing authorities, but some types of sales are exempt. Where such taxes are applicable, the frm collects the tax and forwards the funds to the taxing authority at appropriate intervals. The amounts collected are therefore not part of the frm's permanent usable revenue stream, and must not be included in the sales number from which the calculated gross margin is derived. 46 International Door & Operator Industryâ„¢ $1,000,000 70,000 1,070,000 100.0% Materials & Labor 600,000 62.6% COGS 600,000 60.0% 37.4% Gross Margin 400,000 40.0% Because we discuss margins in percentage terms, the 2.6 margin point difference noted above is far more signifcant than it may seem. When other misinterpretations are added, and when the numbers are larger, the cumulative effects can distort the recognized gross margin to the point of altering critical pricing and business strategy decisions. Exhibit 3 provides a side-by-side comparison of the "Incorrect" and "Correct" calculation of gross margin. As noted earlier, you can use whatever approach you deem satisfactory, but misstating gross margin will inevitably lead to more injurious strategic errors. As displayed in Exhibit 3, Up&Down; Garage Doors, Inc. collected $175,000 of sales tax, which is included in the gross sales fgure (about $2.5 million of taxable sales at 7.0%). Additionally, Up&Down; sustained $12,000 of customer refunds (mistakes or invoice errors) and incurred $36,000 of credit card fees (approximately 3.0% fees on $1.2 million of sales), both of which must be deducted from gross revenues to get to a correct net sales fgure. Again, some will argue that credit card fees are an "expense," not a deduction from sales. But consider the transaction: If a service customer pays a $200 invoice with a credit card that charges the seller a 3.0% fee, only $194 is deposited in the sellers account. A credit card sale is really a discounted transaction, and only the "net" portion can be used to correctly determine gross margin. When considering the minutiae of adjusting gross sales to net sales, always keep in mind that the exercise is necessary to get to correct margin calculations from which correct decisions can be formulated. "Approximately correct" margin information has a great tendency to produce "approximately acceptable" decisions, which put the decision maker at a competitive disadvantage. Accounting for Cost of Materials Used The largest cost item on any garage door dealer income statement is the material used (doors, operators, parts, etc.). Unfortunately, it is also most often stated incorrectly. There are many acceptable and correct ways to handle material cost Continued on page 48

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