When performing profitability analysis, professionals are often concerned with above-the-line cost, or cost associated with making a product. Above-the-line costs are often analyzed separately from those expenses found “below-the-line” because they have a direct impact on gross profit. The concept is pervasive across all industries although the calculations vary slightly.
In this post, we will cover what above-the-line costs are, why they are used in profitability analysis, and some considerations to make when determining which cost to include above-the-line.
What Are Above-The-Line Costs?
Expenses considered to be above-the-line typically include those which are directly related to production of a good or service. This varies slightly depending on whether the business is involved with manufacturing or is a service business.
For most manufacturing businesses, above-the-line costs typically represent the cost of goods sold (COGS). The service sector, however, COGS are included (if applicable), as well as selling, general, and administrative (SG&A) expenses.
Conceptually, above-the-line refers to all costs directly related to the production of a good or service. “The Line” refers to Gross Profit, so any costs included above-the-line will be used to arrive at gross operating profit.
Above-The-Line Costs And Profitability Analysis
The term “above-the-line” can be considered professional jargon that helps to conceptually group expenses into two different categories: those that are related to production and those that are related to operations.
Analysts use above-the-line costs to scrutinize gross profit margins and margin of safety when analyzing a business’s quality of income. Those businesses with low above-the-line costs but high gross profit are considered to have good profit margins.
The separation of above-the-line and below-the-line costs is helpful when trying to determine whether a business’s operations are dragging its net income or whether the product itself has low profit potential.
When considering an acquisition, leaders will often consider whether there are synergies in above-the-line costs that can boost profit margins.
Manufacturing Vs Service Above-The-Line Costs
The primary differences in above-the-line costs between the service and manufacturing industries is that the service sector typically includes the cost of administration as a component of gross profit.
This is because rather than having costs associated with producing a good, businesses that offer a service include certain administrative and other expenses that would otherwise not be incurred if the business wasn’t engaged in performing the service.
Conceptually this makes sense, as the term “above-the-line” refers to all costs that must be incurred in order to produce a product or service.
Considerations To Make When Determining Above-The-Line Costs
In some circumstances, the term above-the-line refers to all income and expenses related to the normal course of business. In this case, any expense above net income would be considered to be above-the-line.
When used in this way, below-the-line expenses include extraordinary and one-time expenses that are typically presented under net income on the income statement. Again conceptually, this use of the term makes good sense, as “the line” gets moved from gross profit to net income.
Like all lingo, above-the-line can have different meanings depending on the type of business. Filmmakers, for example, refer to expenses as being above-the-line if they are related to budgets for directors, actors, writers, and below-the-line if they are related to production staff.
One helpful rule of thumb is to remember that above-the-line costs are almost always considered to be those that are unavoidable when producing a good or service. This in contrast to operating costs which usually include costs like office supplies, management, and departments considered to be cost centers like HR and accounting.
Often, above-the-line costs aren’t fixed and are more variable than operating costs which are usually fixed for budgeting purposes. When managing cost centers, it is more beneficial to have their expenses be as predictable as possible.
Managers pay close attention to above-the-line costs in the short term because any wild fluctuation is an indicator that there is some inefficiency in the production process. This has a direct impact on gross profit, which in turn is monitored to ensure it can cover the operating cost of the business.
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