Gross profit ratio | Gross profit equation
/What is the Gross Profit Ratio?
The gross profit ratio shows the proportion of profits generated by the sale of products or services, before selling and administrative expenses. It is used to examine the ability of a business to create sellable products in a cost-effective manner. The ratio is of some importance, especially when tracked on a trend line, to see if a business can continue to provide products to the marketplace for which customers are willing to pay a reasonable price. There is no optimum ratio amount; it can vary substantially by industry.
How to Calculate the Gross Profit Ratio
The gross profit ratio can be measured in two ways. One is to combine the costs of direct material, direct labor, and overhead, subtract them from sales, and divide the result by sales. This is the more comprehensive approach. The formula is as follows:
(Sales – (Direct materials + Direct Labor + Overhead)) ÷ Sales = Gross profit ratio
However, this first method includes a number of fixed costs. A more restrictive version of the formula is to only include direct materials, which may be the only truly variable element of the cost of goods sold. The formula then becomes:
(Sales – Direct materials) ÷ Sales = Gross profit ratio
The second method presents a more accurate view of the margin generated on each individual sale, irrespective of fixed costs. It is also known as the contribution margin ratio.
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Example of the Gross Profit Ratio
Quest Adventure Gear has been suffering declining net profits for several years, so a financial analyst investigates the reason for the change. She discovers that the costs of direct materials and direct labor have not changed significantly as a percentage of sales. However, she notes that the company opened a new production facility three years ago to accommodate increased sales volume, but that sales flattened shortly thereafter. The result has been increased factory overhead costs associated with the new facility, without a sufficient amount of offsetting sales to maintain an adequate profit level.
Based on this analysis, management decides to shutter the new facility, which will result in a 10% decline in sales, but also a 30% increase in gross profit, since so much of the cost of goods sold will be eliminated.
Analysis of the Gross Profit Ratio
From a management perspective, the gross profit ratio is not of much use, because it encompasses the sales and costs of many products, spanning multiple product lines and sales regions. In order to conduct a proper analysis, you should break it down into manageable pieces. This means deriving a gross profit ratio for every product, product line, sales region, subsidiary, and so forth, and then identify those outcomes that deviate from the company average for the ratio. You can then review the above-average areas to determine why they are producing such excellent margins, while also examining the poor-performing areas for problems. It may be possible to transfer some of the best practices from your best areas to the low-performing areas. It may also be necessary to prune out low-performing products, sales regions, or salespeople as a result of this analysis. By taking this detailed approach, you can slowly improve on your gross profit ratio outcomes.
Problems with the Gross Profit Ratio
There are some limitations associated with the gross profit ratio, which are as follows:
Ignores operating and non-operating costs. The ratio only focuses on gross profit and does not account for other expenses such as operating expenses, administrative costs, interest, and taxes. This can give an incomplete picture of overall profitability.
Does not reflect cash flow. The gross profit ratio does not show whether the company has adequate cash flow, which is crucial for day-to-day operations.
Sensitivity to pricing changes. Changes in pricing strategies (e.g., discounts, promotional pricing) can distort the gross profit ratio without reflecting true operational efficiency.
Inability to detect cost inefficiencies. The ratio does not reveal inefficiencies in operations, such as wasteful use of materials or labor inefficiencies, that can erode profit margins.
Ignores changes in product mix. If a company sells multiple products with varying profit margins, a change in the product mix can affect the gross profit ratio without indicating a real change in profitability.
No insight into cost behavior. The ratio does not distinguish between variable and fixed costs, which can provide insights into how costs change with production or sales volumes.
In summary, while the gross profit ratio is useful for analyzing profitability at a high level, its limitations mean it should be used alongside other financial metrics to gain a complete understanding of a company’s financial health.