Gross Profit Margin and Profit Margin - Case Study Example

Auditing Assignment Name Course Instructor College Date of Submission Gross Profit Margin and Profit Margin Majority of the businesses scrutinize their gross profit margin along with the profit margin time and again to gauge their achievement as well as effectiveness. Gross profit is the income left after subtracting the costs of production from the total sales revenue. Gross profit margin is the proportion of a business’s gross profit to the revenue for the period under consideration expressed in percentage form. It is a technique used to measure the efficiency by which the business turns revenues into profits; it is also a measure of profitability. Profit margin is the proportion of the business’s entire income that is left after subtracting all the operating costs. A business’s end goal is to increase its profit margins. However, this may not always be achieved as the profit margins may as well decrease. Understanding changes in gross profit margin and profit margin is crucial when conducting an audit. Factors That Could Lead to Increased Gross Profit Margin and Decreased Profit Margin Reduction in Material and labour costs The cost of production forms the basis of analyzing the gross profit margin. The cost of materials forms a large part of the total cost of production. If the cost of materials is reduced, the production costs would go down thus boost the gross profit margin. A reduction in material cost can be achieved through improved pricing from suppliers, changing to cheaper materials employed in production or else changing to suppliers with better pricing. Similarly, labour costs form an important constituent of the production costs. A reduction in labour cost per unit of product makes production more efficient. Labour costs can be reduced via training of workers to be more efficient or investment in superior equipment. If labour cost is reduced, the gross profit margin will go up. Better Pricing and Improved Sales If a company increases prices and maintains its sales volume, the wholesome sales figure will go up. If the production costs remain the same as before, the gross profit margin will go up. Similarly, an increase in sales volume, holding prices and production costs constant, the gross profit margin would go up. Change in Inventory Accounting Methods Stock forms part of the items used to calculate the cost of goods sold. In accounting, there are several methods that can be used to estimate the value of stock at the end of an accounting period. Consider two approaches; the Last in First out (LIFO) approach and the First in First out (FIFO) approach. Using the first approach (LIFO), variable costs are traced for the most lately acquired merchandise first as items are sold out whereas with FIFO one records the costs of the first obtained inventory first. These approaches do not have an effect on revenue. A change from LIFO to FIFO translates to lower costs irrespective of inflationary conditions leading to a higher gross profit margin. Misconceptions The gross profit margin is based on just two variables that are the cost of goods sold along with the revenues obtained from sales. Gross profit margin does not account for other costs incurred by a company in its day-to-day operations such as rent or tax. These costs however affect the profit margins. Therefore a decline in profit margins would occur if a business incurs greater operational costs that include rent and rates, taxes, and electricity and telephone bills, among others. Profit margin could as well be reduced when a company offers significant discounts (discounts allowed) and increased interest expenses. Audit Work Planning In carrying out a financial audit, the auditor is required to evaluate the inherent risk linked to the revenue flow and conduct tests to find out if there is fraud. The inherent risk is connected to the sales as well as likely pressures from those in power to misstate incomes. In planning for the audit, the auditor needs to carry out substantive tests along with tests of controls to investigate whether there is proper recording of incomes (Maroney, 211; AASB, 2013). From the indications above, revenue issues may be pegged to batch sales, refunds, total sales and bills. The management may exert pressure for revenue misstatement to attract investors or else make an impact on the general management. Issues pertaining human error cannot be ruled out along with making records at the wrong time. In audit planning, the auditor has to extend his operations to understand the industry and in particular, the business entity to better assesses the auditing procedures (Patterson & Smith, 2003). As regards this situation, the analytical procedures could touch on a number of ratios apart from the gross profit margin and the profit margin only. The auditor should assess the gross profit margin along with the company’s growth over the 2011-2012 financial years. The auditor should scrutinize the company’s maximum aptitude for sales. Other accounts to look at are the accounts receivables to make sure that they do not exceed the amount of sales. Should the accounts receivable exceed the sales volume, there is likelihood for probable credit risk (AASB, 2013). Carrying out substantive tests will assist in spotting any mistakes or else misstatements inside the accounts or records linked to the revenue flow. The tests possibly will entail going through the trial balance to confirm whether the amounts received by the company as well as debtors. It is also important to review the accuracy of allowances on accounts receivable plus the sales returns (Maroney, 211; Patterson & Smith, 2003). Featherbed Background Information and Impact on Audit Risk and Preliminary Materiality Assessment PM is based on audit risk evaluation. If considered detection risk (DR) is stumpy, PM is as well set low. DR is dogged by the inherent risk (IR) along with control risk (CR) appraisal. If IR and CR are high, DR is lower (Patterson & Smith, 2003). Concerns that would impact IR and CR, and consequently DR and PM as regards Featherbed are: Featherbed wide-ranging operations that translate to numerous sources of income form a multiplicity of inherent risks greater than sustainability of revenue streams. The client does not provide information relating to virtual dependence on each one revenue item could translate to diverse levels of materiality. Justin and Sarah Morris are the owners of majority of shares in Morris group which runs Featherbed. In addition Justin is the chairman of the Board of Directors of Featherbed along with Morris group and Sarah is a director of both companies as well as the CFO of Featherbed. As a result, Justin and Sarah Morris jointly have effective (not entire) authority over the big business. This generates contradictory incentives plus perplexed lines of reporting and power posing a question of whether there is helpful control. These circumstances suggest a higher risk and lower PM for dealings stuck between the companies. Surprisingly, the client has never been audited in earlier times. As a result, the risk connected to balances brought forward cannot be based on earlier audit findings. This translates to lower PM for balances forwarded and review of previous period accounting principles as well as their appliance. The entrance of a new private equity investor group that controls 20 percent of the client’s total stake creates extra need (including appeal from bank for audit) for financial reports. The situation boosts audit risk, suggestive of lower PM. The management has a ‘laid back’ style of admin, demonstrating that efficient operation of Featherbed is absent. Justin and Sarah Morris rely on their workers to work hard for the company and they recompense them generously. The setting is indicative of greater control risk from ‘tone at the top’ matters thus implying lower PM. In particular the accounts staff is exceedingly loyal to the extent that some workers never take annual leaves even when they are ailing. This shows that there has not been an opportunity for their work to be evaluated autonomously. This could suggest that they may perhaps be hiding something. Control risk from ineffective management and separation of duties, no chance to employ a different staff member in key roles results to lower PM. Moreover, Peter Pinn is closing in to retirement age and as a consequence has a short ‘horizon’ in the company. Effective supervision of casual workers is missing. In business, there are people expected to have inducement for asset misuse because of their low pay. The staff possibly will have a mind-set that fraud is sensible due to the pitiable working environment in addition to low pay. However, one staff member is a graduate, suggesting accounting expertise. Generally, these circumstances lead to greater CR and therefore lower PM. The accounting staff does not have appropriate procedures for handing out the short-term employment contracts. Also, Featherbed does not have a person in charge of human resource duties. This is suggestive of disparity in work force as well as troubles in payroll and HR. The outcome of this is greater risk and lower PM for payroll. Lastly, the company is facing increased risk to its feasibility as a result of changing climatic conditions in the area. On the whole, there appear to be a number of issues with the business, mainly in its governance and staffing. These issues craft questions regarding particular control risks which would be evaluated in more detail. Greater control risks imply lower detection risk and lower PM would be suitable (Blokdijk et al, 2003). References AASB 2013, Australian Auditing Standards, viewed 28 April 2013, Blokdijk, H., Drieenhuizen, F., Simunic, D., and Stein, M. (2003), Factors Affecting Auditors' Assessments of Planning Materiality, Auditing: A Journal of Practice & Theory, 22(2), 297-307. Moroney, C.H. (2011), Auditing A Practical Approach, Milton, Wiley Patterson, E., and Smith, R. 2003, Materiality Uncertainty and Earnings Misstatement, The Accounting Review, 78(3), 819-846 Read More