What is Gross Profit Ratio
The Gross Profit ratio informs the company’s management about its profitability. It informs the company’s management about the company’s production costs. When management compares it to the prior year’s ratios, it learns how well the firm did and how to enhance its efficiency even more. The Gross Profit Ratio provides information regarding sales as well. It tells management whether or not sales have risen or dropped. As a result, management takes the necessary actions.
Gross Profit Ratio Formula
There are two ways to calculate the gross margin ratio.
(Sales – (Direct materials + Direct Labor + Overhead)) / Sales
This first option, however, has a lot of fixed expenditures. A more stringent version of the calculation includes only direct materials, which may be the only really changeable component of the cost of products sold. The formula is then as follows:
(Sales – Direct materials) / Sales
This ratio may also be calculated using the following formula:
Gross Profit Ratio = (Gross Profit / Sales) x 100 Equals
The ratio is the percentage of sales retained as gross profit by the firm. For example, if the ratio is 10%, it means that for every $1 of revenue collected, $0.10 is retained and $0.90 is credited to the cost of goods sold.
Advantages of Gross Profit Ratio
- The GP Ratio, which compares net sales to the company’s gross profit, allows users to determine the profit margin earned by the company’s trading and manufacturing activities.
- It decides how much the firm earns in excess of what it must spend in operational expenditures.
- It aids in the inter-firm comparison of trading activity outcomes.
- Gross Profit indicates how a firm is performing in relation to its competition since the higher a company’s efficiency, the higher its gross profit.
- It determines the company’s competitive advantage in the market.
- Comparing the Gross Profit ratio over time help in assessing the company’s pace of growth.
- This margin enables the creation of budgets and projections.
Limitation of Gross Profit Ratios
- It does not account for the company’s costs, which are normally carried off to the Profit and Loss Account.
- It is only a passive indicator of the company’s overall health. A corporation may have a positive gross profit margin, but when all other expenditures are included, the resulting profit may be extremely low, or the company may even be losing money. As a result, the gross profit % is not a measure against which the company’s overall profitability can be assessed or rated.
Key Point to Remember about Gross Profit Ratio
If the Gross Profit Ratio analysis found an increase in the percentage then we can reach one of the following conclusions:
- The value of the Opening Stock is understated, while the value of the Closing Stock is overstated.
- The selling price of the items rises without a matching rise in the cost of goods sold.
- Similarly, there is a reduction in the cost of items sold without a matching reduction in the selling price of the commodities.
- Errors in documenting purchases or sales statistics must have occurred.
- Purchases may have been omitted, or sales statistics may have been recorded in excess of actual sales, i.e., overstated.
If the Gross Profit analysis indicates a decrease in the percentage then we can conclude one of the following:
- The Opening Stock’s value is overstated, or perhaps the Closing Stock’s value is understated.
- The selling price of the items falls without a matching drop in the cost of goods sold.
- Similarly, there is a rise in the cost of items sold that does not correlate to an increase in the selling price of the commodities.
- Errors in documenting purchases or sales statistics must have occurred.
- Sales may have been ignored, or purchase statistics may have been recorded in excess of actual sales, i.e., overstated.
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