Financial Management 101 - The Lowdown on Calculating Gross Profits - 5/31/2004 - Mortgage Loan Refinance Debt Equity

Financial Management 101: The Lowdown on Calculating Gross Profits

Gross profit is pretty easy to define. It’s sales minus the cost of sales. As an equation, gross profit looks like this:

Sales – Cost of Sales = Gross Profit

Sales are also easy to define: The term refers to revenue from the sales of homes, which typically is recorded at closing or transfer of ownership.

Cost of sales, however, cannot be nailed down with one pat definition. For one thing, there are two traditional ways to calculate cost of sales: direct costing and absorption costing. For another, while some people factor in “soft costs” when calculating cost of sales, some don’t.

Confusing? Here’s how to sort it out.

Direct costing. If you use this method to calculate cost of sales, include only direct construction costs. These costs are directly attached to the product and typically include the costs of the lot, materials and labor.

Absorption costing. If you use this method to calculate cost of sales, figure out your direct construction costs and add a proportionate amount of indirect construction costs (also known as construction overhead). Indirect costs are the costs of running the construction process and often include superintendents’ salaries, field offices, trucks, construction equipment, temporary toilets, clean-up, etc.

Soft costs. These typically include sales commissions, other sales and marketing expenses, financing and closing expenses.

The following table illustrates two ways of calculating gross profit and includes an example of soft costs. Notice that the calculations vary according to the number of cost and expense items included in the cost of sales computations. Net operating income is the same under each method, as each one accounts for the same dollar amount of costs and expenses. The difference is whether the expenses are recognized above the gross profit line or below it.

Gross Profit Calculation Methods

Which Calculation Method Is Best Depends Upon Who Wants to Know

Which method should you use to calculate gross profit? That depends on who needs the information.

For management reports, I recommend the use of the direct costing method with the separate recognition of lot cost and direct construction costs. Indirect construction costs and other unit related expenses should be accumulated by category (indirect construction cost, financing and closing expenses, sales and marketing expenses and general and administrative expenses) below the gross profit line.

Segregated costs and expenses let management easily evaluate the performance of each cost and expense category. Each line item clearly identifies the performance of individual areas such as product cost, cost of the land, efficiency of construction operation, sales and marketing, financing and general management.

Generally accepted accounting principles and the Internal Revenue Service both require the use of absorption costing to calculate gross profit information reported to third parties like lenders, investors and state or federal tax jurisdictions

It’s not a good idea to use absorption costing for management reports because this method clouds the cost of sales classification by including items other than lot and product costs.

However, it’s very easy to convert from direct costing to absorption costing. You can do this by allocating the indirect construction costs to both the work-in-process inventory and the cost of sales based on the annual activity and cost incurred during the period.

For example, let’s assume a builder has direct construction costs of $3.5 million and indirect construction costs of $122,500 during the year. He closes $3 million worth of product and keeps $500,000 of product in inventory.

To calculate the relationship of indirect costs to direct costs, divide the former by the latter:

$122,500/$3,500,000 = 3.5%

To allocate the proportional share of indirect costs to work-in-process inventory, multiply the amount of product in inventory by 3.5%:

$500,000 x 3.5% = $17,500

To allocate the proportional share of indirect costs to cost of sales, multiply the amount of product sold by 3.5%:

$3,000,000 x 3.5% = $105,000

Add $105,000 and $17,500 and you get $122,500. The portion relating to the amount of product closed ($105,000) gets allocated to cost of sales. The portion relating to inventory ($17,500) gets allocated to work in process.

To calculate gross profits for comparison with another company, it is cleaner to use the direct cost method. To make the comparison meaningful, it is essential to first define cost of sales and then make adjustments, if necessary, to the same basis.

Emma S. Shinn, a certified public accountant and author or "Accounting and Financial Management, 4th Edition," has worked in the home building industry since 1970. She is a business consultant with the Lee Evans Group in Littleton, CO, and is a guest lecturer at universities and home builder seminars. She is an active contributor to and past chair of NAHB’s Business Management & Information Technology Committee.