Reasons for a Decline in Operating Profit
Finding the reasons for a decline in operating profit is difficult since such decline can be caused by various factors that interact with one another. The best way to know the reason for a decline in operating profit is to understand the mechanics of accounting that cause such a situation. Failure to understand these mechanics leaves your small business vulnerable to a net loss.
Sales less cost of goods sold yields gross profit, and deducting operating expenses from gross profit results in operating profit. As an example, a company that generates sales of $1,000 with an $800 cost of goods sold and expenses of $150 will yield an operating profit of $50, i.e., $1,000 minus $800 minus $150. Operating profit refers to profit from the company's core business operations. Transactions not part of day-to-day activities, such as investments, interest and taxes, are not included when computing operating profit. This basic accounting formula guides you in identifying whether a transaction will increase or decrease your operating profit.
Cost of goods sold and operating expenses make up the total expenses that are deducted from sales to produce the operating profit. The difference between total expenses and total sales determines your operating profit. Any business activity that reduces this difference qualifies as a reason for a decline in operating profit. Inversely, any activity that increases such difference improves operating profit. With all factors being equal, decreasing your selling prices is an example of a business action that causes the difference between total expenses and total sales to become smaller.
Any decline in sales accompanied by an equivalent amount of decline in the sum of cost of goods sold and expenses will not affect your operating profit. If the decline in sales results to a smaller decline in the sum of operating expenses and cost of goods sold, your operating profit will go down. For example, a company that decreases sales by $10,000 and cuts expenses, including cost of goods sold, by only $8,000 will experience a decline in operating profit. Cost of goods sold typically goes down when sales is decreased, but some expenses are not affected by a decrease in sales.
The saying that fewer expenses mean more profit is not always true. If the decrease in expenses results in a bigger decrease in sales, operating profit will go down. An example of this situation is when a manager cuts back on monthly advertising costs and realizes that sales have gone down by an amount greater than the cost savings.