Gross Profit Margin Ratio, Defined and Explained
Why is Gross Profit Ratio Important?
The following are some key justifications for the significance of gross profit ratio:
It gives management a clear idea of how much capital they can reinvest
Knowing how much of your revenue remains after deducting all costs is essential because it informs management of how much of the remaining revenue can be reinvested in the business. A high gross profit ratio enables those in charge of expanding the business to allocate funds for boosting brand recognition, hiring new employees, and other ways to improve the business.
It can attract or discourage investors
It can give a company the flexibility it needs
No matter how much revenue a business generates, if its gross profit ratio is low, there won’t be much room for error in its operations. A company’s operations, production costs, material costs, or the markets it serves could change at any time, potentially turning it from profitable to losing money.
However, a high gross profit ratio enables the business to continue operating profitably despite any such changes, giving management more leeway to try new things.
Its typically difficult to change
It’s typically very challenging to increase a company’s gross profit margin because doing so typically calls for a complete overhaul of its operations. Therefore, establishing a favorable gross profit-to-total sales ratio as soon as possible can be crucial for the future of the business.
What is the Gross Profit Ratio?
By calculating the total sales over a specific time period and subtracting the total costs of the labor and materials used to create the products and services that the company is selling, the gross profit figure of the business is calculated. The business’s net sales figure includes all of its gross sales for a given time period as well as income from other sources, such as interest, rent from rented properties, royalties, or other sources, less returns, allowances, and discounts.
Gross Profit Ratio Formula
The formula for calculating the gross profit ratio is:
The difference between the cost of goods sold and the total net sales is the gross profit. By adding the opening stock, total purchases, and direct expenses, if any, and then deducting the closing stock, the cost of goods sold is calculated.
After combining cash and credit sales, the net sales figure is calculated. The sales returns are then subtracted.
How to Calculate Gross Profit Ratio
When determining the gross profit ratio, the following procedures must be followed:
1. Gather all the required metrics
Key financial metrics, such as the following, must be understood in order to calculate a company’s gross profit ratio over a specific time period:
2. Calculate net sales and gross profit
The two components of the gross profit ratio—gross profit and net sales—must be calculated after gathering the necessary metrics. You must calculate the net sales figure by adding the cash and credit sales and subtracting the sales returns after determining the cost of goods sold by adding the opening stock, purchases, and expenses, and then subtracting the closing stock. The cost of goods sold must be subtracted from the net sales figure to calculate gross profit.
3. Apply the gross profit ratio formula
By dividing the gross profit by the net sales, the gross profit ratio is calculated. The result is typically multiplied by 100 so that it can be expressed as a percentage to make it simpler to read and compare. This makes it possible for you to calculate the company’s profit margin.
Gross Profit Ratio Examples
Here are some examples of gross profit ratio:
Example 1
Flagtastic, a company that creates and manufactures flags, generates annual sales of $100. 000. Their cost of goods sold for the same year was $43 000. As a result, the gross profit of the business can be determined by deducting the 43 000 from the 100. 000, resulting in a $57. 000 profit.
Now that we are aware of the two components of the formula for the gross profit ratio, we can determine its value by dividing the gross profit by the total amount of sales.
57.000/100.000=0.57
Then, by multiplying it by 100, we can express it as a percentage.
0.57*100=57
The company has a gross profit ratio of 0. 43 and a gross profit margin of 57%.
Example 2
Fedora is a furniture company with net sales of $250. 000 over the course of a calendar year. At the start of the year, their opening stock had a value of $112. 000 and have spent $54 worth of raw materials over the course of the year. 000. They also spent $9. 000 on various expenses. At the end of the year, they still had $23. 000 worth of goods in stock.
The first step is calculating the cost of goods sold.
112.000+54.000+9.000-23.000=152.000
By deducting the cost of goods sold from the total net sales, gross profit is calculated.
250.000-152.000= 98.000
Finally, using its formula, we can determine the gross profit ratio.
98.000/250.000=0.39
0.39*100= 39
The company has a gross profit ratio of 0. 39 and a gross profit margin of 39%.
