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Gross Profit Ratio = (Gross profit / Net sales) × 100
Net Sales is the value of total sales less the value of items returned.
Gross profit is the difference between revenue or the net sales proceeds and the input cost to manufacture the product or render the service.
Gross Profit = Value of Total Sales Collection – Cost incurred to produce the product sold.
Gross profit is achieved before deducting overhead expenses such as rent, staff salaries, taxes, and interest payments from the revenue. Operating profit, in contrast, comes after deducting all overheads such as rent and salaries connected with the sale, but excludes interest and taxes.
Deriving the cost incurred to produce the product is easy for a merchandiser or a trader, and entails computing the total value of closing stock inventory less opening stock, plus purchases made during the accounting period.
The procedure for deriving costs incurred to produce the product is complex for a manufacturer or service provider, and requires adding the cost of input raw materials and other direct costs incurred to transform the raw materials into the finished product, such as machinery costs, direct labor costs, and energy charges. A service provider needs to add up the direct cost involved in each process that contributes to the service.
Image Credit: flickr.com/Hobvias Sudoneighm
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Companies can increase their gross profit ratio by increasing the selling price of goods sold without any corresponding increase in input costs, or decreasing input costs without a corresponding decrease in selling price.
A decrease in gross profit ratios may be owing to:
- Decrease in price owing to competitive pressures without decrease in input costs
- Increase in raw material or input costs with the selling price remaining constant
- Unfavorable purchasing or markup
- Inability to improve sales volume
- Over valuation of opening stock or undervaluation of closing stock
Undervaluation of opening stock or over valuation of closing stock may act as a major distorter that increases gross profit ratio. Similarly, over valuation of opening stock or undervaluation of closing stock may distort gross profit ratios negatively.
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A gross profit ratio is an important indicator of the operational efficiency of a firm. Although there is no standard gross profit, and the optimal ratio depends on the industry, as a rule of thumb, the higher the gross profit ratio, the better the profits. This becomes useful to value disproportionately sized firms with different and incomparable product ranges and product mixes.
Another use of gross profit ratio is to determine the extent to which the selling price may be reduced without incurring losses on operations.
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Assume a gasket manufacturing company has total sales of $75,000 for the accounting period, and the suppliers have rejected one batch worth $1,500 during this period.
Assume the total cost to run the factory during the accounting period as follows:
- Raw materials: $20,000
- Electricity: $7,250
- Packing & delivery: $8,500
- Labor use in production: $7,500
- Support staff wages: $7,000
- Rent: $12,000
- Machinery deprecation: $2,000
- Other administrative costs: $6,000
- Marketing expenses: $5,000
The first step in calculating gross profit ratio is identifying direct costs and eliminating overheads and indirect costs from the list of expenses. This requires elimination of staff wages, rent, marketing expenses, and other administrative costs that do not require consideration when computing input costs.
Total input costs = $20,000 + $7,250 + $8,500 + $7,500 + $2,000 = $25,250
Net Sales = $75,000 (total revenue) – $15,000 (returns) = $735,000
Gross Profit: $735,000 (net sales) - $25,250 (total input costs) = $48,250
Gross Profit Ratio = ($48,250/$73,500) * 100 = 65.64%
In another gross profit ratio example, assume a trading company has stock worth $20,000 at the start of the accounting period, makes additional purchases of $35,000 during the accounting period, and has a stock of $25,000 at the end of the accounting period.
Assume net sales during the period at $50,000 with no refunds or returns.
Input costs = Closing Stock-Opening Stock + Purchases = $25,000 - $20,000 + $30,000 = $35,000
Gross Profit = $50,000 (total revenue) - $35,000 (input costs) = $15,000
Gross Profit Ratio in this case = [$15,000 (Gross Profit) / $50,000 (net sales) ] x 100 = 30%
This means that for every $1 of revenue, 70 cents goes toward meeting the cost of the product sold and 30 cents is available for meeting overhead costs and profits.