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ICAEW ACA Business Insight and Performance study materials
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ICAEW ACA Business Insight and Performance practice questions

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Question 1Business Insight and Performance

A company's statement of profit or loss shows revenue of $500,000, cost of sales of $300,000 and operating expenses of $120,000. What is the gross profit margin?

  1. 24%
  2. 60%
  3. 40% Correct answer.
  4. 16%

Explanation

Gross profit is revenue minus cost of sales, so $500,000 − $300,000 = $200,000. The gross profit margin expresses this as a percentage of revenue: $200,000 ÷ $500,000 = 40%. Operating expenses are deducted later to reach operating profit and do not affect the gross margin.

Question 2Business Insight and Performance

Which ratio best measures how efficiently a business converts its inventory into sales over a period?

  1. Dividend cover
  2. Gearing
  3. Inventory turnover Correct answer.
  4. Current ratio

Explanation

Inventory turnover compares cost of sales with average inventory, showing how many times stock is sold and replaced in a period. A higher turnover generally indicates faster movement of stock and less capital tied up. The other ratios address liquidity, long-term financing structure or shareholder returns.

Question 3Business Insight and Performance

A business has current assets of $180,000, inventory of $60,000 and current liabilities of $90,000. What is the quick (acid-test) ratio?

  1. 0.67
  2. 1.33 Correct answer.
  3. 2.00
  4. 0.33

Explanation

The quick ratio removes inventory from current assets because stock may be slow to convert into cash. Quick assets are $180,000 − $60,000 = $120,000, divided by current liabilities of $90,000, giving 1.33. A result above 1 suggests liquid assets cover short-term obligations.

Question 4Business Insight and Performance

Which of the following best describes the purpose of a company's mission statement?

  1. To record the legal ownership structure of the entity
  2. To summarise the prior year's financial results
  3. To state the fundamental purpose and reason the organisation exists Correct answer.
  4. To set the detailed annual budget for each department

Explanation

A mission statement articulates the organisation's core purpose and the value it seeks to create for stakeholders. It guides strategic decision-making rather than detailing operational or financial specifics. Budgets, ownership records and results summaries are separate documents with narrower functions.

Question 5Business Insight and Performance

A firm's PESTLE analysis identifies a new government subsidy for renewable energy. Under which PESTLE category does this fall?

  1. Legal
  2. Social
  3. Technological
  4. Political Correct answer.

Explanation

Government subsidies and policy incentives are political factors because they stem from government decisions and priorities. PESTLE separates these from legal, economic, social, technological and environmental influences. Recognising the correct category helps a business assess how policy changes may affect its strategy.

Question 6Business Insight and Performance

Which of the following is an example of a business using a cost leadership strategy?

  1. A consultancy competing on bespoke service for each client
  2. A luxury watchmaker emphasising craftsmanship and exclusivity
  3. A retailer offering a unique product range found nowhere else
  4. A budget airline standardising its fleet to offer the lowest fares in the market Correct answer.

Explanation

Cost leadership means becoming the lowest-cost producer in a market and competing primarily on price. Standardising the fleet reduces operating costs and supports low fares. Differentiation strategies instead compete on uniqueness, quality or service.

Question 7Business Insight and Performance

Which stakeholder group is most directly interested in a company's dividend policy?

  1. Employees' trade unions
  2. Trade suppliers
  3. Local environmental groups
  4. Shareholders Correct answer.

Explanation

Shareholders own equity and receive returns through dividends and capital growth, so dividend policy directly affects them. Suppliers are concerned with payment terms, unions with pay and conditions, and environmental groups with impact. Each stakeholder has distinct interests in the organisation.

Question 8Business Insight and Performance

A company's share price is $4.00 and its earnings per share is $0.50. What is the price-to-earnings (P/E) ratio?

  1. 2
  2. 0.125
  3. 4.5
  4. 8 Correct answer.

Explanation

The P/E ratio divides the market price per share by earnings per share: $4.00 ÷ $0.50 = 8. It indicates how many years of current earnings investors are paying for, and is widely used to compare market valuations.

Question 9Business Insight and Performance

A business sells 10,000 units at $20 each. Variable costs are $12 per unit and fixed costs total $50,000. What is the margin of safety in units?

  1. 3,750 units Correct answer.
  2. 6,250 units
  3. 1,250 units
  4. 10,000 units

Explanation

Contribution per unit is $20 − $12 = $8, so break-even units are $50,000 ÷ $8 = 6,250. Margin of safety is actual sales minus break-even sales: 10,000 − 6,250 = 3,750 units. It measures how far sales can fall before a loss arises.

Question 10Business Insight and Performance

Which of the following best explains why a company might prefer debt finance to equity finance?

  1. Interest payments vary with profit
  2. Debt never has to be repaid
  3. Debt holders gain voting control of the company
  4. Interest is generally tax-deductible while dividends are not Correct answer.

Explanation

Interest on debt is typically an allowable deduction for tax, creating a tax shield that lowers the effective cost of borrowing. Dividends are paid from post-tax profit and offer no such benefit. Debt must still be repaid and lenders do not normally obtain voting control.

Question 11Business Insight and Performance

A company's gearing ratio (debt to equity) is 150%. Which statement best describes the implication?

  1. The company's interest cover must be above 5 times
  2. The company relies heavily on debt and carries higher financial risk Correct answer.
  3. The company is highly liquid and faces no repayment risk
  4. The company has more equity than debt in its capital structure

Explanation

A gearing of 150% means debt is one and a half times equity, indicating a capital structure dominated by borrowing. High gearing increases fixed interest obligations and financial risk, particularly if profits fall. It does not by itself establish liquidity or interest cover levels.

Question 12Business Insight and Performance

Which of the following is the most appropriate measure of a company's ability to meet interest payments from operating profit?

  1. Interest cover Correct answer.
  2. Return on equity
  3. Asset turnover
  4. Dividend cover

Explanation

Interest cover divides operating profit by interest payable and shows how many times profit covers the interest charge. A higher figure indicates greater safety for lenders. The other ratios measure shareholder distributions, asset efficiency or returns to owners.

Question 13Business Insight and Performance

A company's receivables collection period has risen from 45 days to 70 days. What is the most likely implication?

  1. More cash is tied up in receivables and liquidity may weaken Correct answer.
  2. The company is paying its suppliers more slowly
  3. Gross profit margin has increased
  4. Inventory is being sold more quickly

Explanation

A longer receivables collection period means customers are taking more time to pay, so cash is locked up in trade receivables. This can strain working capital and reduce available liquidity. It says nothing directly about payables, inventory turnover or margins.

Question 14Business Insight and Performance

Which of the following describes the 'threat of new entrants' in Porter's Five Forces framework?

  1. The intensity of rivalry among existing firms
  2. The ease with which new competitors can enter the industry and erode profits Correct answer.
  3. The bargaining strength of customers over price
  4. The availability of substitute products from other industries

Explanation

The threat of new entrants assesses how easily new competitors can join the market, which depends on barriers such as capital, regulation and brand loyalty. High barriers reduce the threat and protect incumbent profitability. The other options describe distinct forces in the framework.

Question 15Business Insight and Performance

A company's revenue increased by 15% while its operating profit increased by 30%. Which explanation is most consistent with these figures?

  1. The company paid a larger dividend
  2. Operating costs grew more slowly than revenue, creating operating leverage Correct answer.
  3. The company reduced its selling prices significantly
  4. Cost of sales rose faster than revenue

Explanation

When profit grows faster than revenue, costs are rising more slowly than sales, so each additional dollar of revenue contributes more to profit. This reflects operating leverage and improved cost control. Faster cost growth or price cuts would compress margins instead.

Question 16Business Insight and Performance

Which of the following best describes the role of corporate governance?

  1. To prepare the detailed monthly management accounts
  2. To design the company's advertising campaigns
  3. To negotiate collective pay agreements with unions
  4. To ensure the company is directed and controlled in the interests of shareholders and stakeholders Correct answer.

Explanation

Corporate governance concerns the systems, principles and processes by which companies are directed and controlled. It addresses accountability, board composition, risk oversight and the alignment of management with stakeholder interests. The other options are operational or functional tasks.

Question 17Business Insight and Performance

A firm uses a SWOT analysis. Which item would most appropriately be classified as an opportunity?

  1. Weak internal controls in the finance department
  2. A competitor launching a superior product
  3. A highly skilled workforce
  4. A new export market opening due to a trade agreement Correct answer.

Explanation

Opportunities are favourable external conditions the business could exploit, such as a new market created by a trade agreement. Strengths and weaknesses are internal, while threats are adverse external factors. Classifying items correctly matters because strategies respond differently to internal and external factors.

Question 18Business Insight and Performance

A project requires an initial investment of $100,000 and generates annual cash inflows of $30,000 for five years. Ignoring discounting, what is the payback period?

  1. 4.00 years
  2. 5.00 years
  3. 2.50 years
  4. 3.33 years Correct answer.

Explanation

Payback period is the time needed for cumulative cash inflows to recover the initial outlay. Dividing $100,000 by $30,000 gives 3.33 years. Payback ignores the time value of money and cash flows after the payback point.

Question 19Business Insight and Performance

Which statement best explains the concept of net present value (NPV) in investment appraisal?

  1. It expresses annual profit as a percentage of capital employed
  2. It calculates the time taken to recover the initial investment
  3. It discounts future cash flows to today's value and deducts the initial outlay Correct answer.
  4. It measures the accounting profit generated in the first year

Explanation

NPV discounts all expected future cash flows at the cost of capital and subtracts the initial investment. A positive NPV indicates the project should add value to the firm. It is based on cash flows and the time value of money, unlike payback or accounting-based measures.

Question 20Business Insight and Performance

A business has a contribution-to-sales ratio of 40% and fixed costs of $120,000. What is the break-even revenue?

  1. $480,000
  2. $48,000
  3. $200,000
  4. $300,000 Correct answer.

Explanation

Break-even revenue equals fixed costs divided by the contribution-to-sales ratio: $120,000 ÷ 0.40 = $300,000. At this level of revenue, total contribution exactly covers fixed costs and profit is zero. Contribution margin analysis links cost structure directly to the break-even point.

Question 21Business Insight and Performance

An investor buys a share for $5.00 and receives a dividend of $0.25 during the year. The share is worth $5.50 at year end. What is the total shareholder return?

  1. 15% Correct answer.
  2. 12.5%
  3. 10%
  4. 5%

Explanation

Total shareholder return combines capital gain and dividend: ($5.50 − $5.00) + $0.25 = $0.75 gain on a $5.00 investment. Dividing $0.75 by $5.00 gives 15%. It captures both income and capital elements of the return.

Question 22Business Insight and Performance

A company reports a current ratio of 2.5 but a quick ratio of 0.6. Which conclusion is most defensible?

  1. The company has an unusually strong ability to pay current liabilities from cash
  2. The company is insolvent because the quick ratio is below 1
  3. The company's gearing is dangerously high
  4. Liquidity depends heavily on selling inventory to meet short-term obligations Correct answer.

Explanation

A large gap between the current and quick ratios indicates that inventory makes up most current assets. If stock is slow-moving, the business may struggle to settle liabilities without converting inventory into cash. A quick ratio below 1 is not automatic insolvency, and gearing cannot be inferred from these ratios.

Question 23Business Insight and Performance

Two projects each have a positive NPV. Project A has an NPV of $80,000 with a payback of four years; Project B has an NPV of $50,000 with a payback of two years. If the projects are mutually exclusive and capital is not rationed, which should be chosen and why?

  1. Project B, because it recovers cash more quickly
  2. Project B, because it has a shorter payback and lower risk
  3. Either project, because both have positive NPV
  4. Project A, because it adds more value in present-value terms Correct answer.

Explanation

For mutually exclusive projects where capital is available, NPV is the preferred decision rule because it measures the absolute increase in shareholder wealth. Project A's higher NPV indicates greater value creation despite slower payback. Payback ignores cash flows after the cut-off and the time value of money.

Question 24Business Insight and Performance

A firm's operating profit margin is 12% and its asset turnover is 1.5 times. Using the DuPont relationship, what is its return on total assets?

  1. 13.5%
  2. 18% Correct answer.
  3. 9%
  4. 8%

Explanation

The DuPont relationship multiplies operating profit margin by asset turnover to give return on total assets: 12% × 1.5 = 18%. This decomposition shows that returns come from both profitability and efficient use of assets. Improving either driver raises the overall return.

Question 25Business Insight and Performance

A company's inventory holding period lengthens while its payables payment period shortens. Assuming receivables are unchanged, what is the most likely effect on the cash operating cycle?

  1. The cycle is unaffected because only receivables matter
  2. The cycle shortens because suppliers are paid sooner
  3. The cycle shortens, releasing cash
  4. The cycle lengthens, increasing the need for working capital finance Correct answer.

Explanation

The cash operating cycle equals inventory days plus receivables days minus payables days. Longer inventory holding adds days, while a shorter payables period reduces the deduction, so both changes lengthen the cycle. A longer cycle means more cash is tied up and more working capital finance is required.

Question 26Business Insight and Performance

Under the IASB's Conceptual Framework, which qualitative characteristic is enhanced when information is complete, neutral and free from error?

  1. Relevance
  2. Comparability
  3. Faithful representation Correct answer.
  4. Timeliness

Explanation

Faithful representation requires that information depicts economic substance completely, neutrally and without material error. Relevance concerns predictive and confirmatory value, while comparability and timeliness are enhancing characteristics rather than the completeness-neutrality-error triad.

Question 27Business Insight and Performance

A company pays $60,000 for a machine with an estimated residual value of $10,000 and a useful life of five years. Using straight-line depreciation, what is the annual depreciation charge?

  1. $14,000
  2. $8,000
  3. $12,000
  4. $10,000 Correct answer.

Explanation

Straight-line depreciation spreads the depreciable amount, being cost less residual value, evenly over the useful life. Here $60,000 less $10,000 equals $50,000, divided by five years gives $10,000 per year.

Question 28Business Insight and Performance

Which costing method is most appropriate for a manufacturer producing large volumes of identical, homogeneous units in a continuous process?

  1. Job costing
  2. Process costing Correct answer.
  3. Batch costing
  4. Specific order costing

Explanation

Process costing accumulates costs by department or process and averages them over equivalent units, which suits continuous homogeneous production. Job and specific order costing suit identifiable, customised outputs, and batch costing suits distinguishable groups of similar units.

Question 29Business Insight and Performance

A business has a gross profit margin of 25% and reports revenue of $800,000. What is its gross profit?

  1. $200,000 Correct answer.
  2. $160,000
  3. $600,000
  4. $240,000

Explanation

Gross profit margin expresses gross profit as a percentage of revenue, so gross profit equals 25% multiplied by $800,000, which is $200,000. Cost of sales would then be the remaining $600,000.

Question 30Business Insight and Performance

Which of the following best describes the purpose of a statement of cash flows prepared under IAS 7?

  1. To show the profit earned by operating activities during the period
  2. To explain the movement in cash and cash equivalents by operating, investing and financing activities Correct answer.
  3. To value the entity's assets at fair value at the reporting date
  4. To reconcile the opening and closing balances of retained earnings

Explanation

IAS 7 requires a statement of cash flows that analyses movements in cash and cash equivalents across operating, investing and financing activities. It supplements the income statement because profit and cash generation differ, and it does not reconcile retained earnings or revalue assets.

Question 31Business Insight and Performance

In the context of budgeting, which variance arises when actual sales volume differs from budgeted sales volume while standard contribution per unit is held constant?

  1. Material usage variance
  2. Sales price variance
  3. Fixed overhead expenditure variance
  4. Sales volume contribution variance Correct answer.

Explanation

The sales volume contribution variance isolates the effect of selling a different quantity from budget, valued at standard contribution per unit. Price, overhead expenditure and material usage variances each isolate different causes of the total difference.

Question 32Business Insight and Performance

Which of the following is the best example of a business using a differentiation strategy rather than a cost leadership strategy?

  1. A budget airline removing free meals to reduce ticket prices
  2. A supermarket negotiating bulk discounts to undercut rivals
  3. A luxury watchmaker investing in hand-finished movements and heritage branding Correct answer.
  4. A manufacturer relocating production to a low-wage country

Explanation

Differentiation competes on perceived uniqueness that supports a price premium, such as craftsmanship and brand heritage. The other options reduce cost per unit to compete on price, which is characteristic of cost leadership.

Question 33Business Insight and Performance

Which of the following best describes the purpose of an audit committee within a listed company's governance structure?

  1. To manage the company's day-to-day operations on behalf of the board
  2. To provide independent oversight of financial reporting, internal control and the external audit Correct answer.
  3. To set the remuneration of executive directors
  4. To represent shareholders at the annual general meeting

Explanation

An audit committee, composed mainly of independent non-executive directors, oversees the integrity of financial reporting, the effectiveness of internal control and the relationship with external auditors. Remuneration is normally handled by a separate remuneration committee, and executive management runs operations.

Question 34Business Insight and Performance

A company's dividend cover has fallen from 4.0 times to 2.0 times while earnings per share remained constant. Which explanation is most consistent with this movement?

  1. The company reduced its interest charge
  2. The company issued new ordinary shares at a premium
  3. The company doubled the dividend per share Correct answer.
  4. The company halved the dividend per share

Explanation

Dividend cover equals earnings per share divided by dividend per share, so with constant earnings a fall from 4.0 to 2.0 means dividend per share doubled. New share issues or lower interest would change earnings per share, which the question holds constant.

Question 35Business Insight and Performance

A company has inventory of $40,000, trade receivables of $60,000, cash of $10,000, current liabilities of $100,000 and a bank overdraft of $20,000 included within current liabilities. What is the quick ratio?

  1. 0.83
  2. 0.70 Correct answer.
  3. 0.58
  4. 1.10

Explanation

The quick ratio excludes inventory from current assets and divides by current liabilities. Current assets less inventory are $60,000 plus $10,000, or $70,000, and dividing by $100,000 gives 0.70.

Question 36Business Insight and Performance

A company is considering a project with an internal rate of return (IRR) of 14% and a cost of capital of 10%. Which statement is correct?

  1. The IRR cannot be compared with the cost of capital
  2. The project has a negative net present value and should be rejected
  3. The project should be accepted only if its payback period is under three years
  4. The project has a positive net present value and is financially acceptable Correct answer.

Explanation

A project whose IRR exceeds the cost of capital generates a positive net present value when discounted at the cost of capital. Because 14% exceeds 10%, the project adds value and is acceptable on this criterion.

Question 37Business Insight and Performance

A company's operating profit margin is 8% and its asset turnover is 2.0 times. Using the DuPont relationship, what is its return on total assets?

  1. 10%
  2. 16% Correct answer.
  3. 25%
  4. 4%

Explanation

Return on total assets equals operating profit margin multiplied by asset turnover. Multiplying 8% by 2.0 gives 16%, showing the combined effect of profitability and asset efficiency.

Question 38Business Insight and Performance

Which of the following best explains why a company's operating cash flow can exceed its operating profit in a period of sales growth?

  1. Non-cash charges such as depreciation are added back, and cash collected may exceed profit recognised Correct answer.
  2. Tax paid is always lower than the tax charge in the income statement
  3. Capital expenditure is classified as an operating activity
  4. Depreciation is added back and working capital absorption is lower than the non-cash charges

Explanation

Operating cash flow starts from profit and adds back non-cash charges such as depreciation, so it can exceed profit even before working capital effects. Where customers pay promptly or in advance, cash collected can also run ahead of revenue recognised.

Question 39Business Insight and Performance

A company has fixed costs of $90,000, a selling price of $30 per unit and variable cost of $18 per unit. What is the margin of safety in units if budgeted sales are 10,000 units?

  1. 1,500 units
  2. 7,500 units
  3. 2,500 units Correct answer.
  4. 5,000 units

Explanation

Contribution per unit is $12, so break-even units are $90,000 divided by $12, which is 7,500 units. The margin of safety is budgeted sales of 10,000 less 7,500, giving 2,500 units.

Question 40Business Insight and Performance

A firm's payables payment period has increased from 40 days to 65 days while purchases remained constant. Which interpretation is most defensible?

  1. The firm is taking longer to pay suppliers, which improves short-term cash flow but may risk supplier goodwill Correct answer.
  2. The firm has reduced its inventory holding period
  3. The firm's credit sales have slowed, increasing receivables
  4. The firm is settling suppliers more quickly, improving supplier relations

Explanation

A longer payables period means the firm retains cash for longer before paying suppliers, which is a source of short-term finance. The trade-off is potential loss of early settlement discounts and damage to supplier relationships.

Question 41Business Insight and Performance

Which of the following best describes the role of a company's nomination committee?

  1. To determine the audit fee and appoint the external auditor
  2. To lead the process for board appointments and recommend candidates for director roles Correct answer.
  3. To approve the annual financial statements before publication
  4. To set the company's overall strategic direction

Explanation

A nomination committee identifies and recommends candidates for board appointment and oversees succession planning for directors and senior management. Financial statement approval, auditor appointment and strategy are handled by the board or other committees.

Question 42Business Insight and Performance

A company's inventory turnover is 6 times per year and its gross profit margin is 20%. If annual revenue is $1,200,000, what is the average inventory value?

  1. $1,000,000
  2. $160,000 Correct answer.
  3. $240,000
  4. $200,000

Explanation

Cost of sales is 80% of $1,200,000, which is $960,000. Inventory turnover of 6 times means average inventory equals $960,000 divided by 6, giving $160,000.

Question 43Business Insight and Performance

Which of the following best explains the concept of economic value added (EVA) as a performance measure?

  1. It measures profit after deducting a charge for the cost of capital employed Correct answer.
  2. It measures the surplus of cash receipts over cash payments in a period
  3. It measures the market value of equity less the book value of equity
  4. It measures residual income before any charge for invested capital

Explanation

EVA is a residual income measure that deducts a capital charge, being invested capital multiplied by the weighted average cost of capital, from after-tax operating profit. It therefore reflects whether a company earns more than its cost of capital.

Question 44Business Insight and Performance

A company's share price is $6.00, earnings per share is $0.40 and dividend per share is $0.16. What is the dividend yield?

  1. 2.5%
  2. 2.7% Correct answer.
  3. 40.0%
  4. 6.7%

Explanation

Dividend yield equals dividend per share divided by market price per share. Dividing $0.16 by $6.00 gives approximately 2.7%, which shows the cash return to an investor at the current price.

Question 45Business Insight and Performance

A company is highly geared and has a covenant requiring interest cover above 3.0 times. Which action would most directly improve interest cover without changing operating profit?

  1. Issuing new shares to fund a major acquisition
  2. Extending the payables payment period
  3. Increasing dividend payments to shareholders
  4. Refinancing high-interest debt with lower-interest debt Correct answer.

Explanation

Interest cover equals operating profit divided by finance costs, so reducing the interest rate on debt directly lowers finance costs and raises cover. Higher dividends, acquisitions and payables timing do not reduce the interest burden in the same direct way.

Question 46Business Insight and Performance

A company has a contribution-to-sales ratio of 30% and fixed costs of $150,000. If it wishes to achieve a target profit of $60,000, what revenue is required?

  1. $500,000
  2. $700,000 Correct answer.
  3. $600,000
  4. $210,000

Explanation

Required revenue equals fixed costs plus target profit, divided by the contribution-to-sales ratio. Adding $150,000 and $60,000 gives $210,000, and dividing by 0.30 gives $700,000.

Question 47Business Insight and Performance

A company is evaluating a project with cash inflows of $50,000 per year for four years and an initial outlay of $150,000. At a discount rate of 10%, the relevant annuity factor is 3.170. What is the net present value?

  1. -$8,500
  2. $158,500
  3. $50,000
  4. $8,500 Correct answer.

Explanation

The present value of inflows is $50,000 multiplied by 3.170, which is $158,500. Deducting the $150,000 outlay gives a positive NPV of $8,500, so the project is acceptable on this basis.

Question 48Business Insight and Performance

A company's return on capital employed is 15% and its weighted average cost of capital is 12%. Which conclusion is most defensible for a value-based performance assessment?

  1. The company is destroying value because its return exceeds its cost of capital
  2. The company's value creation cannot be assessed without its dividend policy
  3. The company should reduce its capital employed regardless of returns
  4. The company is creating value because its return exceeds its cost of capital Correct answer.

Explanation

When return on capital employed exceeds the weighted average cost of capital, the spread is positive and the company earns more than the capital providers require, which creates economic value. Dividend policy affects distribution rather than the underlying spread.

Question 49Business Insight and Performance

A company reports revenue of $2,000,000, a gross profit margin of 40% and an operating profit margin of 15%. If distribution costs are $200,000, what is the amount of administrative expenses?

  1. $200,000
  2. $800,000
  3. $300,000 Correct answer.
  4. $500,000

Explanation

Gross profit is 40% of $2,000,000, or $800,000, and operating profit is 15% of $2,000,000, or $300,000. The total of distribution and administrative expenses is therefore $500,000, so administrative expenses are $500,000 less $200,000, which is $300,000.

Question 50Business Insight and Performance

An analyst notes that a company's operating profit margin has fallen while its gross profit margin has remained stable. Which explanation is most consistent with this pattern?

  1. The company has increased its selling prices without any change in costs
  2. The cost of raw materials has risen sharply
  3. Distribution and administrative costs have increased as a proportion of revenue Correct answer.
  4. Depreciation of production machinery has been reclassified as cost of sales

Explanation

A stable gross margin means cost of sales has kept pace with revenue, so the decline must arise below the gross profit line. Rising operating expenses such as distribution or administration therefore explain the fall in operating margin.