How to explain the impact of Sales Variances on Profitability or Profit Margin of a business? In this article, I am going to explain with the help of an example, how to calculate sales variances, and how to understand the impact of these variances on the profitability of your business. Note that we are calculating the impact of Sales Variances on Profit. This is different from explaining sales variances in $.
By the time, you are finished with the article, you will be able to understand clearly how to calculate these variances. I will try to be concise, so I assume you are already aware of terms like Sales, margin, profits and variance etc. If you are not fully aware, click on Commonly used financial terms every new Financial Analyst and Accountant should know! to open the post and have a good idea of what they mean. Also, start following our blog and YouTube channel LearnAccountingFinance, so that you can stay up to date with practical information and training (knowledge you can use immediately at your work).
What you will learn?
We will start with data in the following example. The example uses data for 2017 and 2018 (current year vs last year) to calculate the variances. However, if you are trying to calculate variance with budget, simply replace last year (2017) with Budget and the calculation will work just fine.
We are selling three products which are fruits 1) Apples, 2) Bananas and 3) Oranges. We have data for Sales, Cost of Sales and Profit Margins. We also have the quantity, or number of units sold. See Tables below
As this article is about calculating the impact of Sales variances on Profit margins, we have deliberately kept the cost per unit as same over the two periods to avoid confusion. However, when calculated correctly, it does not matter if cost per unit has changed. The only thing to consider in that case would be that the profit margin change would have an element of variances from costs as well which needs to be calculated separately. In our example however, the profit margin increased by $268 and all of it is resulting from Sales related variances. After performing all variance calculations, you will see the split of variances as follows:
Types of Sales Variances
Lets look at types of sales variances quickly. Broadly, there are only two types of Sales variances.
- Price Variance (Change in Selling Price)
- Volume Variance (Change in Volume)
The Volume variance is further sub-divided into Quantity and Mix Variances. Do you like acronyms. Here is a good one to remember. Its PVTM
where ‘P’ is for Price Variance, and ‘V’ is for Volume Variance. ‘T’ for Quantity and ‘M’ is for Mix.
If we calculate our variances correctly, the sum of Price and Volume variances should be equal to the total change in Profit Margin (excluding the impact of Cost variances). Similarly the sum of Quantity and Mix variances should equal Volume variance. Its time to calculate each of these variances individually.
Selling Price Variance
Lets deal with Price variance first. Any change in price directly impacts Profit margin From the data available, you can easily calculate the Selling price per unit of each fruit (Sales $ for each fruit sold divided by the number of units sold). So, for example for Apples, the selling price for 2018 is $11 ($660 Sales / 60 units sold). Similarly, the selling price of apples in 2017 was $10. Below is the table of selling prices per unit.
Looking at the table above, we can clearly see that the Selling price for apples and oranges have increased in 2018 compared to previous year, while that of bananas has decreased. This means, if we look at Selling prices alone, we should see a favorable impact, or favorable variance from apples and oranges and unfavorable impact from bananas. Now, Selling Price variance will be calculated as follows:
(2018 Selling price – 2017 Selling price) x Units sold in 2018.
For apples, this can be calculated as:
($11 – $10) x 60 units = $60 Fav.
Why did we use 2018 number of units sold, and not 2017 units? The answer is that we are trying to determine the impact of change in Selling price. In other words, we are trying to see if the 60 apples sold in 2018 were sold at 2017 price, how would this compare with 2018 price. Therefore, the variance could also be calculated as follows:
Apples sold at 2018 Price – Apples sold at 2017 Price
which is …
($11 x 60) – ($10 x 60) = $60
Apply the same logic to bananas and oranges
Bananas Sales Price variance = ($1.5 – $2) x 95 = -$48 Unfav. (numbers are rounded)
Oranges Sales Price variance = ($10 – $8) x 50 = $100 Fav
Here is the summary of Selling price variances,
So, we can say out of total change in profit margin of $268, Price variance represents $113 (rounded), and we can also see that oranges are the largest contributors to the fav. price variance.
This leads to the calculation of our second variance, Sales Volume variance. Sales variances comprise of Price and Volume only. Since we have calculated Price variance already, we can already calculate the total volume variance which would be…
Sales Volume variance = Total Sales Variance – Sales Price Variance
$268 – $113 = $155
However, we need to still calculate it, as well as the two sub Volume variances, which are Quantity and Mix.
Lets start with Volume variance.
Sales Volume Variance =
(2018 Units Sold – 2017 Units Sold) x 2017 Profit Margin per Unit
Yes, I know you have some questions here.
- Why did we use Profit Margin per unit, and not Selling Price?
- OK, even if we use Profit Margin, why 2017 and not 2018.
See .. I can read your mind 🙂
Answer to Question 1. Remember we are trying to explain the impact of Sales variances on profit margin, not total Sales $. If we had taken Selling price instead of Profit margin, we would be explaining Sales $ variance (change in Sales $ from 2017 to 2018), but we are calculating the impact on Profit margin. For each increase or decrease in unit sold vs last year, the profit margin will be impacted only by the amount of profit margin per unit and not the total Sales value. Understanding this is important. Note that in the calculation of two sub Volume variances (Mix and Quantity) as well, we will use profit margin per unit and not Selling price per unit.
If you have understood answer to Q1, then you can also understand that when we calculated price variance, we took into account the change in profit margin per unit in 2018. Now we are calculating the impact of change in volume (or number of units) and should exclude the impact of change in Profit margin in 2018. This is why we use 2017 Profit Margin. Think about it for a little while, internalize it and if you still do not understand, leave a comment and I will try to explain further.
Time to do the Math:
At this point, we have understood the impact of Sale price and volume on the $268 change in Profit Margin in 2018 vs 2017.
However, our analysis is not finished, and we need to understand the impact of Mix and Quantity.
Sales Mix Variance:
Sales Mix refers to the share of each product in total Sales, in terms of percentage. If you look at the number of units sold, you will see that in 2017, 50 apples were sold which is 28% of total sales of 180 units (50/180).
Sales Mix variance can be calculated as …
(2018 Mix % – 2017 Mix %) x Total units sold in 2018 x 2017 Profit Margin
So, our Sales Mix variance for each fruit will be as follows:
The share of apples in the overall product mix increased to 29% in 2018 (60/205). This change in mix of 1% multiplied by the total number of units sold in 2018 (205) will give us the number of apples sold that resulted in the increase in Mix %. In this case it is 3 apples (1% x 205 = 3). We know that the total number of apples increased by 10 (50 in 2017 and 60 in 2018). So out of the total Volume change of 10 apples, 3 apples represent Mix change and the remaining 7 represent Quantity change. We can see from the variances above that a drop in mix % of bananas by -9% has impacted the profit margin unfavorably by -$19 but this has been more than compensated by the increase in Mix % of Oranges by 8% (which has a higher Profit margin per Unit compared to bananas).
Calculating Mix variance separately in this way is important because each product may have a different profit margin. Assume the overall volume increased from 180 to 205 (just as in our example) but the mix remained the same as last year, then the change in total profit margin of the business would have been different, although we see the same quantity increase. This calculation of impact of increase in quantity while maintaining the same mix as last year is really our next variance, the Quantity Variance. Calculating Mix variance also helps when trying to explain Profit Margin % changes over the years, or vs budget because Quantity variance has neutral impact on % Profit Margin.
Sales Quantity Variance
As mentioned above, Sales Quantity variance measures the impact of increase in volume, or quantity while maintaining previous year’s mix.
Sales Quantity Variance
= (2018 Units sold @ 2017 Mix – 2017 Units Sold) x 2017 Profit Margin per unit
In our example fruit sales increased from 180 to 205. If the sale had increased maintaining the same product mix as 2017, our unit sales for 2018 would be as follows:
And the Sales Quantity Variance can be calculated as follows:
We have calculated all the variances now. The overall increase of $268 in Profit margin can be clearly explained with Price increase resulting in fav. variance of $113 and Volume increase resulting in fav. variance of $155. The volume increase includes $76 due to change in Product Mix.
If you are also interested in learning how to calculate purchase price variance and the accounting entries involved in recording purchase price variance, click on the link How to calculate Purchase Price Variance (PPV) and track PPV accounting entries in SAP
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