Common-Size Analysis 2

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By:Hendru Chahayo, SE.

(HCO)

Common-Size Analysis

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Basic of common size analysis

Although company A has higher net income, it is not necessarily the more profitable when

adjusted for size. Company B had 700 (million) lower sales, but generated only 50 (million)

Less in earnings.

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Vertical common size incomestatement

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Summary Company B is doing better job than Company A

of controlling its product cost (has a lowerCOGS).

Company A is doing better job of controllingselling and administrative expenses.

Company As tax expense as a percentage ofrevenues is lower than Company B

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Continue Company A has an average tax rate 30%

(165/550).

Company B has an average tax rate of 29.5%(140/475).

It appears that Company B is doing a better job atcontrolling tax expense.

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Horizontal common size incomestatement

Revenues in the second year increased by 10% whereas net income increased by only

about 9%.

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Summary COGS increased by just 8.7% whereas revenues

increased 10%.

Gross profit increased by 12.5% (more than theincrease in revenue).

Unfortunately, selling and administrative expenseincreased by 15.38%.

Earnings increased by 9.09%.

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Fixed Costs VS Variable Costs

Company C is selling goods at $25 per unit. Cost of sales are $15 per unit.Selling and administrative cost are $6 per unit. Taxes are 30%. The companycurrently selling 50,000 units, and sales are increasing at 20% per year.

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Vertical common size

Note that because all expenses are variable costs and did not change (in percentageterms), the net income as a percentage of sales is constant at 11.2%.

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Scenario DAlthough company D is in the same industry, it has some FC as part of itsOperating structure. Selling and adm costs are $100,000 per year (fixed) plus$4 per unit (variable).

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Converting to common size yield

Although the net profit margin was 11.20% for both company C and company D inthe first year, company Ds net profit margin increased to 12.13% in year 2 and 12.91%in year 3.

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Why did this occur? Because the FC did not increase as sales grew. The companys cost structure enabled it to

leverage the 20% sales increase to a largerincrease in net income.

This is known as operating leverage.

On a horizontal basis, the 20% increase in salesyielded a 30% increase in operating income and

net income.

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Operating Leverage

In this case, operating leverage is 1.50 (300/200).As seen earlier, a 20% increase in sales yielded a 30% increase in operatingincome.

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Continue Operating leverage=

percentage change in EBIT

percentage change in revenue

This would result in the same 1.5 (30%/20%).

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ContinueAssume that 50% of the companys FC ($50,000)

are based on sales of less than 80,000 units.Every time sales increase cumulatively by 80,000units, an additional $50,000 of FC will be

increased . Company D had 72,000 units of sales in year 3,

so it will incur an additional $50,000 in cost inyear 4.

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