Definition
The gross profit index is an operating performance measure that allows analysts to understand if the gross profit margin is changing significantly over time. When the gross profit index varies considerably from 1.0, it may indicate irregularities in the reporting of profits.
Calculation
Gross Profit Index = Gross Profit Margin in Period 2 / Gross Profit Margin in Period 1
Where:
Gross Profit Margin = Gross Profits / Sales
Explanation
Operating performance measures allow the investor-analyst to understand how well a company is performing with respect to sales, margins, and profits. The gross profit index helps the analyst to detect significant changes in a company's gross profit margin over time. The index normalizes the current period's gross profit margin by dividing it by the value found in the previous period.
Since the gross profit margin should remain fairly stable from period to period, the analyst should expect the index to remain close to 1.0. When the index varies significantly from 1.0, this may be an indication of fraudulent reporting activity or an error in the prior or current period.
Example
After reporting unusually high margins in the current period's draft financial statement, Company A's CFO ordered their internal auditing department to quickly compare the draft income statement with those of the prior period. One of the screening tests the internal auditors conducted was the calculation of the gross profit index. The results of this analysis appear in the table below:
Current Year | Prior Year | |
Gross Sales | $9,774,000 | $10,213,000 |
Less: Sales Allowances and Returns | $1,256,000 | $656,000 |
Net Sales | $8,518,000 | $9,557,000 |
Less: Cost of Goods Sold | $5,536,000 | $5,784,000 |
Gross Profit Margin | $2,982,000 | $3,773,000 |
Gross Profit Margin (%) | 30.5% | 36.9% |
Gross Profit Index | 0.83 |
The internal auditors found the gross profit index varied significantly from 1.0, indicating a problem in the current period's draft income statement. Subsequent to this finding, the auditors discovered a clerical error resulting in the overstatement of sales allowances and returns.
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