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Why Including Labor Costs in Gross Margin is a Bad Idea in Your Management Accounts



gross margin analysis in a set of management accounts

As a business owner, you might have come across advice suggesting that you include labor costs in your gross margin calculation when you are looking at your management accounts. I recently watched a podcast where this was recommended, but based on my nearly 20 years of experience as a chartered accountant, I believe this approach is flawed. In this blog post, I'll explain why this method doesn't work well for most businesses and share a better alternative.


Understanding Gross Margin


First, let's clarify some terms. Gross margin, also known as gross profit or margin, is calculated as sales minus direct costs. While there are technical differences among these terms, for small businesses, we can use them interchangeably.


Direct costs are those that vary directly with sales volume. For instance, if your sales increase, your direct costs should also rise proportionately. This relationship helps you understand the true profitability of your products or services.


The Problem with Including Labor Costs in Gross Margin


Including labor costs in your gross margin can obscure your financial analysis. This is because most employees today are on fixed salaries rather than hourly wages. This means that their costs don't vary directly with sales volume. For example, if you hire a new full-time employee, your labor cost increases regardless of your sales. This inconsistency disrupts the correlation between sales and direct costs, making it harder to gauge your true gross margin.


This then leads to complex Analysis as when you include labor costs in gross margin, you need to remove them again to understand your actual gross margin. This additional step complicates your analysis and can lead to inaccurate conclusions about your business performance.


Recommended Approach: Separating Costs for Clarity


To avoid these issues, I recommend structuring your profit and loss statement more effectively:


1. Sales and True Direct Costs: Calculate your gross margin using only true direct costs, excluding labor costs. This will give you a clearer picture of how your sales relate to your direct costs and help you understand your gross margin percentage accurately.


2. Detailed Expense Categories: Instead of lumping all expenses into a single "admin" category, break them down into more specific categories. This is especially important for labor costs.

  • Marketing Costs: Include all expenses related to promoting your business.

  • Sales and Production Costs: This category should encompass all costs related to producing and selling your products, including labor costs for your production or warehouse staff.

  • Property Costs - This could include rent, rates, utilities etc

  • Administrative overheads - This should include all other costs, including the salaries of any admin staff you have.



Conclusion


Including labor costs in your gross margin can distort your financial analysis, making it difficult to understand your true profitability. By separating these costs and structuring your profit and loss statement with detailed categories, you can gain a clearer, more accurate view of your business's financial health. This approach not only simplifies your analysis but also helps you make more informed decisions to drive your business forward.

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