Gross Profit Ratio

What is the Gross Profit Ratio?

Gross profit ratio is a profitability measure that is calculated as the ratio of Gross Profit (GP) to Net Sales and therefore shows how much profit the company generates after deducting its cost of revenues.Cost Of Revenues.The cost of revenue is the total expense incurred from manufacturing to delivering a product or service to the customer. It reflects all direct costs associated with the product or service delivered and is reflected in a company's income statements.read more

Gross Profit Ratio Formula

Let us see how Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more can be calculated.

Gross Profit = Net Sales – Cost of Goods Sold

Now, for obtaining gross profit by using the above equation, we need to find out two other values, i.e., Net Sales and Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more.

First, let us look into the value of ‘Net sales.’

The next value we need to obtain is the ‘Cost of Goods Sold.’

Cost of Goods Sold = Opening Stock + Purchases*- Closing Stock + Any Direct Expenses Incurred.

*Purchases imply Net Purchases, i.e., Purchases minus Purchase Returns.

After obtaining all the above values, we can now compute the GP Ratio as follows:

Gross Profit Ratio Formula = (Gross Profit/Net Sales) X 100

(usually expressed in the form of a percentage)

Gross-Profit-Ratio

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For eg:
Source: Gross Profit Ratio (wallstreetmojo.com)

From the above computations, we can say that we require the following values in order to obtain the Gross Profit Ratio:

  • Total Sales
  • Sales Returns (If any)
  • Opening Stock of Goods
  • Purchases made during the period
  • Purchase Returns (If any)
  • Closing stock, i.e., Stock at the end of the period for which we are computing the ratio.
  • Direct Expenses Incurred.

As we can see, all these amounts can be picked up from the Trading Account of a concern.

Gross Profit Ratio Examples

Let us understand the calculation of gross profit ratio with the help of an example:

You can download this Gross Profit Ratio Excel Template here – Gross Profit Ratio Excel Template
ParticularsAmount ($)ParticularsAmount ($)
Opening stock35,000Closing Stock15,000
Sales200,000Sales Returns20,000
Purchase80,000Purchase Returns6,500

#1 – Net Sales

Net Sales Example 1-2

#2 – Cost of Goods Sold (COGS)

COGS Example 1-1

#3 – Gross Profit

Example 1-3

Finally,

#4 – Gross Profit Ratio Formula

Gross Profit Ratio Example 1-4

Let us now move on to the significance and implications of the Gross Profit Ratio.

Advantages

Limitations

Important Points to Remember about GP Ratio

If the analysis of the Gross Profit trend indicates an increase in the percentage, we can arrive at any of the following conclusions:

If the analysis of the Gross Profit trend indicates a decrease in the percentageDecrease In The PercentageDecrease Percentage refers to a quantity’s rate of reduction in relation to its original value (in finance, price change of a security) & this is expressed as a percentage. You can calculate it by, Decrease Percentage = {(Original Value – New Value)/Original Value} *100 read more, we can arrive at any of the following conclusions:

  • The value of the Opening Stock is overstated, or the value of the Closing Stock is understated.
  • There is a decrease in the selling price of the goods without a corresponding decrease in the cost of goods sold.
  • In a similar manner, there is an increase in the cost of goods sold without a corresponding increase in the selling price of the goods.
  • There must have been errors while recording the purchases or sales figures. Sales might have been omitted, or purchase figures might have been recorded in excess than the actual sales made, i.e., boosted.

In short, Gross Profit (GP) ratio is a measure that shows the relationship between the Gross Profit earned by an entity and the Net Sales of the company in a manner that what portion of the Net sales is achieved as the Gross Profit of the company. Though it is a popular and widely used tool for evaluating the operational performance of the business, it is not a complete measure for judging the overall functioning of the company. What would be more useful is the Net Profit Ratio because it takes into account all other expenses also which we shall learn about in another article.

Recommended Articles

This article has been a guide to What is a Gross Profit Ratio, and its meaning. Here we discuss the formula to calculate Gross Profit ratio examples along with advantages and disadvantages. You can learn more about Accounting from the following articles –

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