Does Gross Profit Margin Exclude Salaries?
The gross profit margin is an extremely useful analytical tool for managers. This usefulness comes from its definition: revenue minus cost of goods sold. By defining cost of goods sold to include only those expenses directly related to the creation of a product, managers can effectively evaluate the profitability of business and product lines. Since the value of the gross profit margin relies on the accuracy of reported costs, managers should include some employee salaries in the calculation.
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Direct Labor Defined
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The gross profit calculation traditionally includes the variable costs associated with each dollar of revenue earned. This includes obvious items like wholesale costs or manufacturing supplies and it also includes any direct labor. Direct labor is the compensation for employees that directly create products. This might be a per-piece rate, an hourly wage or a salary, and should include employee benefits like health care costs and 401k contributions. If an employee's time is split between product lines, the cost of that labor should be allocated proportionally to each business line.
Extent of Direct Labor Reporting
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Depending on your analysis, you may allocate salaries if and only if they are directly involved in product creation or you may decide to further allocate the salaries of support staff and fixed resources. In general, however, the costs associated with the GPM should be variable costs---those directly associated with generating the goods or services sold. This means that sales staff and support staff---like human resources and IT---are generally not part of the gross profit calculation.
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Benefits of Direct Labor Allocation
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Adding the cost of direct labor to gross profit analysis ensures that managers see the whole picture when it comes to how the company makes money. If Product A costs $1.50 in supplies and sells for $5.00 while Product B costs $3.00 in supplies and retails for $6.00, it may appear at first that Product A is the more profitable. If, however, the direct labor is $3.00 per piece for Product A and $0.50 per piece for Product B, the picture is very different.
Limits of Direct Labor Allocation
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Direct labor allocations are helpful when one looks at a group as a whole. If, however, the managers use gross profit as a tool for measuring group success, it's important to understand the limits of labor cost allocation. Sub-groups within a product line may have little control over their direct labor costs, and managers should remember this when evaluating team performance.
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