Why Operating Profit Can Fall Even When Revenue Rises 20%
Break down the causes of rising revenue and falling profit into the cost-of-sales ratio and SG&A expenses. Learn how to distinguish temporary costs from recurring deterioration in profitability.
Operating profit falls when cost of sales and selling, general and administrative expenses grow faster than revenue, even if revenue increases. Look beyond revenue growth: subtract incremental SG&A expenses from the increase in gross profit to identify where profit was lost.
Separate the cost-of-sales ratio from increases in expenses
First, record revenue, cost of sales, and SG&A expenses for the two periods in the same units. If gross profit, which is revenue less cost of sales, has declined, start with selling prices, material costs, product mix, or production efficiency. If gross profit has increased but operating profit has fallen, investigate why SG&A expenses such as payroll and advertising have risen. Treating both a higher cost-of-sales ratio and higher SG&A expenses as consequences of revenue growth makes it difficult to judge which costs might reverse next quarter. Record changes in amounts alongside each item as a percentage of revenue.
Examine the profitability of the businesses that grew
Overall profitability can decline if revenue from high-margin products stagnates while only sales of low-margin merchandise grow. Compare a calculation that holds business revenue weights at last year’s mix with one using this year’s actual mix to gauge the effect of the change. IFRS 8 covers disclosures about segments and products, among other things, but does not mean costs are disclosed for every product. Where cost data are unavailable, record only the product-mix changes the company has described as facts, and leave the precise profit contribution as an estimate.
Specify what recovery requires for each cost
For initial costs at a new factory, the conditions for recovery are the mass-production schedule and capacity utilization. If prices were cut to promote sales, the key question is whether volumes hold up after discounts end. Hiring more development staff may create costs that continue into the next quarter, so these should not be excluded as one-time expenses. If you calculate adjusted operating profit, record the amount of each excluded item, whether it may recur, and whether it involved an actual cash outflow. The final step is to avoid interpreting every cost increase positively simply because it is described as an investment in growth.
Worked example
Hypothetical example: Last year, revenue of KRW 100 billion, cost of sales of KRW 70 billion, and SG&A expenses of KRW 20 billion produced operating profit of KRW 10 billion. This year, revenue of KRW 120 billion, cost of sales of KRW 90 billion, and SG&A expenses of KRW 24 billion produce operating profit of KRW 6 billion. Revenue rose 20%, but gross profit stayed at KRW 30 billion and SG&A expenses increased by KRW 4 billion, reducing profit by 40%. The cost-of-sales ratio rose from 70% to 75%, while the operating margin fell from 10% to 5%. Had the cost-of-sales ratio remained at last year’s level, this year’s cost of sales would have been KRW 84 billion and profit KRW 12 billion. The deterioration in the cost-of-sales ratio therefore had a KRW 6 billion impact.
What to check
- Check that the consolidation scope and expense classifications are consistent across both periods.
- Calculate changes in gross profit and SG&A expenses separately.
- Identify the revenue weights and margin differences of the segments that grew.
- Check next quarter whether costs excluded as one-time items recur.
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.