Question

You are asked to conduct an audit by your client, namely PT A, which is engaged in book retail. According to the manager of PT A, the gross margin for the last 4 years has always decreased. The manager said that the drop was due to a drop in sales, as many people switched from buying books at bookstores to buying online. The following is PT A's data for the last four years:

	2017	2018	2019	2020
Sale (thousands)s	47,175	44,039	37,073	35,035
CoGS (thousand)s	30,314	27,998	23,431	22,072
Gross Margin $	16,861	16,041	13,642	12,963
Percent	35,7%	36,4%	36,8%	37%

As a financial auditor, you cannot just trust a statement from a manager. Perform vertical and horizontal analysis on the data above, to answer whether you agree or not with the manager's statement! Explain your answer!

Answer 1

Given:
		2017	2018	2019	2020
	Sales (in thousands)	47,175	44,039	37,073	35,035
	COGS (in thousands)	30,314	27,998	23,431	22,072
	Gross Margin ($)	16,861	16,041	13,642	12,963
	Percent	35.7%	36.4%	36.8%	37.0%

Let us compute percentage change in the sales and COGS amount from year to year -

Horizontal analysis -

	2018	2019	2020
Sales (in thousands)	-6.6%	-15.8%	-5.5%
COGS (in thousands)	-7.6%	-16.3%	-5.8%
Gross Margin ($)	-4.9%	-15.0%	-5.0%

How did we compute this?

• Take difference of current year amount (the year for which you want to compute the ratio) and previous year amount, divide the answer by previous year number.
• Let's understand the same for the year 2018 -
  • Sales - (44,039 - 47,175)/47,175*100
  • COGS - (27,998 - 30,314)/30,314*100
  • Gross Margin - (16,041 - 16,861)/16,861*100

Why did we not compute the same for the year 2017? -

• Simple - we do not have any historical data for the year 2017, with which we can compute the trend.

What do we understand from the trend?

• It is correct that revenue is in the declining trend. However, reduction in the revenue is not the sole reason for fall in gross margin.

How? -

• for this let us understand formula of gross margin -
  • Gross margin is a combined effect of sales and COGS. Hence, the impact shall also be combined

To make it further clear, let us perform vertical analysis (also known as commonsize analysis)-

	2017		2018		2019		2020
Sales (in thousands)	47,175		44,039		37,073		35,035
COGS (in thousands)	30,314	64%	27,998	64%	23,431	63%	22,072	63%
Gross Margin ($)	16,861	36%	16,041	36%	13,642	37%	12,963	37%
Percent	35.7%		36.4%		36.8%		37.0%

Formula:

• Commonsizing for COGS - COGS / Sales
• Commonsizing for Gross Margin - Gross Margin / Sales

We can deduce from the above mentioned table, ratio of COGS and gross margin with sales remains approximately constant over the years.

Summarisation -

• From vertical analysis it is clear that ratio of COGS to sales and Gross margin to sales remains constant.
• Which means even though horizontal movement of the cost and profit are not consistant, movement in gross margin is approximately in line with movement in sales.
• For example in the year 2019, fall in the gross margin (15.0%) is approximately in line with fall in the sales (15.8%).
• Hence with the help of given data we can conclude that, major reason for decrease in gross margin is fall in total sales and we agree with the statement of manager.