Profit is sales minus all costs, so profit falls whenever costs grow by more than the extra sales. Higher sales alone say nothing about profit.
This lesson is part of performance beyond one ratio. It applies the ratios from interpreting financial ratios.
How do I explain a fall in profit when sales rose?
Put the two years side by side and compare every line. The line that grew fastest explains the change.
- Write sales, cost of sales, expenses and net profit for both years.
- Work out the change in each line.
- Find the line that moved most against profit.
- Name a cause from the case.
Worked example: Kedai Sinar
Kedai Sinar is a fictional shop.
| Year 1 (RM) | Year 2 (RM) | |
|---|---|---|
| Sales | 200 000 | 260 000 |
| Cost of sales | 120 000 | 169 000 |
| Gross profit | 80 000 | 91 000 |
| Expenses | 60 000 | 73 000 |
| Net profit | 20 000 | 18 000 |
Check the lines. Sales rose by RM60 000, which is 30%. Cost of sales rose by RM49 000, which is 40.8%.
Expenses rose by RM13 000. Gross profit rose by RM11 000, but expenses rose by RM13 000, so net profit fell by RM2 000.
Margins. Gross margin fell from 40% to 35%, since 91 000 ÷ 260 000 = 35%. Net margin fell from 10% to 6.9%.
Cause from the case. The owner gave discounts to win bigger orders and hired an extra worker. The discounts cut the selling price, so each sale left less gross profit. The extra wages raised expenses.
Conclusion. Higher sales did not produce higher profit, because each extra ringgit of sales brought in less margin and expenses also rose.
Gross profit rose by RM11 000 but expenses rose by RM13 000, which explains the fall.
The mistake that costs marks
The common slip is to write “sales rose, so the business is doing better”.
| Step | Wrong | Right |
|---|---|---|
| Sales | up RM60 000 | up RM60 000 |
| Judgment | doing better | sales up, but profit down RM2 000 |
| Cause | not stated | discounts and extra wages |
| Margin | not calculated | gross margin 40% to 35% |
Sales growth is one line in the table. Profit needs all the lines.
Check yourself
A shop’s sales rose from RM100 000 to RM120 000. Its cost of sales rose from RM60 000 to RM78 000, and its expenses stayed at RM25 000. Did profit rise or fall, and why?
Answer
Year 1 profit = 100 000 − 60 000 − 25 000 = RM15 000.
Year 2 profit = 120 000 − 78 000 − 25 000 = RM17 000.
Profit rose by RM2 000. Sales rose by RM20 000 and cost of sales by RM18 000, so the extra gross profit of RM2 000 flowed through because expenses did not change. The gross margin fell from 40% to 35%, so profit rose by less than sales did.
What to study next
Read comparing ratios only when the periods and definitions align. The cash and profit transaction timeline shows how credit sales affect profit and cash at different times.
For a teacher to go through two-year comparisons with you, see online one-to-one Business tuition.