written by | April 29, 2022

What is the Gross Profit Ratio? Explained in Simple Words

The gross profit ratio measures how much of your revenue is left after the costs of goods are deducted. It is crucial to have a high gross margin because it will allow you to make a net profit for a period.

The gross profit ratio includes revenue and gross profits for the period. To calculate gross profit, subtract the Costs of Goods Sold. You can find these elements in the first section of an income statement. Gross profit is the sum of revenue and Costs of Goods Sold. This gross profit ratio formula divides revenue by gross profit. First, let's check the gross profit ratio and then the formula and other vitals.

Did you know?

Companies use gross profit margin to figure out how efficiently they're making a gross profit from sales of services/products. If a company's net sales revenue is ₹100 and its gross profit of ₹32, its gross profit margin is 32%. For every ₹1 of product sold, the company generates 32 paise in gross profit.

Also Read: What is the Difference Between Gross Profit & Net Profit?

What is the Gross Profit Ratio Formula?

After deducting the cost of products sold, the gross profit margin is the percentage of revenue that remains. The calculation formula is as follows:

Gross Profit Margin = (Net Sales – Cost of Goods Sold)/ Net Sales

Here:

Net sales- are the total sales minus any sales returns, discounts, or allowances. Total sales provide less accurate data than net sales.

COGS (Cost of Goods Sold) - are the direct costs incurred during the manufacturing process, such as direct materials and direct labour. Depending on the company and industry, these prices may differ. Also excluded from the COGS are indirect costs and other fixed expenditures such as administrative and marketing expenses.

What is Gross Profit Ratio?

The gross profit ratio reveals how gross profit is related to net revenue for your business, and it shows that gross profit considers a percentage of revenues from business operations. This figure is calculated in the following manner:

The gross profit ratio is (Gross net revenue and profit of operation). A gross profit ratio is the number of profits used to pay for your company's operational and other expenses. The change in the gross profit ratio reflects changes in the price of sales or revenue cost from operations or both.

If the ratio is low, it indicates unfavourable purchasing and selling policies. If the ratio of gross profits is high, it means it's positive. This suggests you should have more cash in the bank to pay for your company's operating and non-operating costs.

What is the Gross Margin?

Gross margin refers to the profit made after the sale of goods, and before general expenses, interest and administrative expenses are considered. It subtracts the price of goods sold from the net sales. The gross margin could be a particular amount, in which case it is known as "gross profits." The gross margin could also refer to a percentage of an enterprise's sales network.

In this instance, it's referred to as the gross margin ratio, also known as the gross profit percentage. Gross margin is a calculation that you can do for all businesses, and you can calculate gross margins based on the gross profit ratio formula.

Gross Margin vs Profit Margin

We can use gross and profit margins in conjunction, but they differ due to the expenses and exempt they cover. The gross margin and the profit margin are identical. However, the independent word profit margin is a distinct concept that uses an entirely different formula. 

When you study the gross profit ratio formula, you'll see that it doesn't include interest charges and general and administrative costs. The profit margin will consider these costs as the calculation is performed. Businesses may have a greater gross margin, such as 40% but have an even lower profit margin, such as 10% on net revenues.

What is a Decent Marginal Gross Margin?

If you know the true gross profit ratio meaning, there isn't any net profit margin, which you can think to be perfect in all fields. Gross profit margins can vary between industries, and certain industries have a higher gross profit margin, which is good compared to other sectors. 

For example, analysts from the industry observed that some clothing retailers had profit margins of more than 12% in 2018, while other retailers achieved a gross profit margin of about 4%. 

A healthy gross profit margin can also be dependent on how big your company is. If you're a new company, you'll find that your gross profits margins could be less. However, if you have the business experience, you can enjoy more profit margins on your gross profits.

What is the Margin of Net Profit?

Net profit margin can also be known as net margin, profit margin or net income margin. Net profit margin refers to the profit in percentage that a company earns. You can determine it by the total revenue you earn, minus all expenses, including interest, tax and general administrative expenses.

After that, you have to divide it by income and multiply by 100. The net profit margin represents the percentage of revenue you can keep as profit. Like gross margin, it also allows you to assess the level of profitability in your business.

It is a way to gauge how financially healthy your company is and how effectively you keep your expenses minimum. Profit margins on the net are usually lower than the gross margin.

How to Use Gross Profit Margin?

Profit margins in a new venture are typically lower because the company is relatively fresh. Also, it usually takes time to catch efficiency. There are ways to improve efficiency and possibly earn more money. For example, you might consider making a small amount of brand new clothes and observing how they sell out first. After that, run the numbers to decide if the latest clothing collections will remain in place.

The Reason Why Gross Profit is an Important Measurement

When considering an enterprise's financial performance and profitability, it is crucial to consider the gross profit. It will help you by showing how efficient the business is when using its employees, raw materials and other materials.

Many factors can affect the gross profit of your company. The change may result from:

  • The changes in products result in charging premium prices.
  • The efficiency of managing the company that leads to lower-cost sales
  • Certain adjustments in some accounting procedures result in the transfer of costs from cost of sales to overheads or reverse.
  • The purchase of raw materials is at a reasonable cost due to the vertical integration of businesses.

Also Read: Accounting Ratios – Meaning, Types, Formulas

Good Gross Profit in Comparison to Good GPM Ratio

Small business owners should be able to comprehend the financial ratios of their business. Here are a few possible interpretations of that ratio of gross margin.

The Company's Production Efficiency

Gross profit margin is a gauge of the effectiveness of a company's manufacturing process. A higher percentage of gross profit margin signifies a business that effectively produces its product. Financial managers can evaluate your gross profit margin with firms in the same field or across intervals for this particular company.

Low Efficiency of the Production Process

A lower percentage of gross profit margin can indicate the producing company and their product are less efficient. You can determine this by knowing that the exact gross profit margin has declined over time.

Low Sales

A decrease in sales volume could not result in a low gross profit margin. But, if the sales volume isn't enough to cover the costs of other business expenses like sales and administrative costs, then it doesn't matter how much the gross profit margin is.

Poor Pricing Structure

Unwise pricing strategies can result in gross profit margins being low.

Management

Controlling the cost of revenue and items used to increase gross profits is essential to reach the success of a business. You should aim for a steady income and improve it with time. If everything goes fine, you can even surpass the industry standards.

Effective sales and marketing efforts and efficient inventory purchasing to minimise excess inventory can assist you in maintaining your high revenue growth. Reducing waste and negotiating favourable terms for ratios with suppliers can help you improve or stabilise the cost of selling goods.

Conclusion

The gross profit margin ratio formula is a way for a company's management and owners to understand their profitability. It does not consider important financial considerations such as administration and personnel costs, which are also included in the operating profit calculation.

These indirect costs can be a real problem if they are not managed well. Management will often cut back on administration and personnel costs because they won't affect core operations essential to a company's survival.
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FAQs

Q: What should I do to increase my company's gross profit margin ratio?

Ans:

You can put your efforts into any of the following to increase your company's gross profit margin ratio:

  • Lower the manufacturing cost.
  • Increase the selling rates (only if the competition allows you).
  • Set your manufacturing units as close to your target market to cut the maximum transportation costs possible. 
  • Increase production (but ensure you have enough buyers).

Q: What's an ideal gross profit margin ratio?

Ans:

A gross profit margin ratio between 50 to 70% is considered healthy for many businesses, like manufacturers, restaurants, retailers, etc.

Q: What is the gross profit ratio definition?

Ans:

Analysts use gross profit margin to assess a company's financial health. It's the residual amount of money minus the Cost of Goods Sold after product sales.

Q: What is the gross profit ratio formula?

Ans:

Gross Profit Margin = (Revenue minus Cost of Goods Sold) / Revenue x 100). You'll get the percentage.

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