Gross Profit Ratio (GP Ratio):
Definition of gross profit
Gross profit ratio (GP ratio) is the ratio of
gross profit to net sales expressed as a percentage. It expresses the
relationship between gross profit and sales.
The basic components for the calculation of gross profit ratio are gross
profit and net sales. Net sales means that sales minus sales returns. Gross
profit would be the difference between net sales and
cost of goods sold.
of goods sold in the case of a trading concern would be equal to opening stock plus
purchases, minus closing stock plus all direct expenses relating to purchases.
In the case of manufacturing concern, it would be equal to the sum of the cost
of raw materials, wages, direct expenses and all manufacturing expenses. In
other words, generally the expenses charged to profit and loss account or
operating expenses are excluded from the calculation of
cost of goods sold.
Following formula is used to
calculate gross profit ratios:
[Gross Profit Ratio = (Gross profit
/ Net sales) × 100]
Total sales = $520,000; Sales returns = $ 20,000; Cost of goods sold
Required: Calculate gross profit
Gross profit =
[(520,000 – 20,000) – 400,000]
Gross Profit Ratio = (100,000 / 500,000) × 100
Gross profit ratio may be indicated to what extent the selling prices of
goods per unit may be reduced without incurring losses on operations. It
reflects efficiency with which a firm produces its products. As the gross profit
is found by deducting cost of goods sold from net sales, higher the gross profit
better it is. There is no standard GP ratio for evaluation. It may vary from
business to business. However, the gross profit earned should be sufficient to
recover all operating expenses and to build up reserves after paying all fixed
interest charges and dividends.
Causes/reasons of increase or decrease in gross profit ratio:
It should be observed that an increase in the GP ratio may be due to the
- Increase in the selling price of goods sold without any corresponding
increase in the cost of goods sold.
- Decrease in cost of goods sold without corresponding decrease in selling
- Omission of purchase invoices from accounts.
- Under valuation of opening stock or overvaluation of closing stock.
On the other hand, the decrease in the gross profit ratio may be due to the
- Decrease in the selling price of goods, without corresponding decrease in
the cost of goods sold.
- Increase in the cost of goods sold without any increase in selling price.
- Unfavorable purchasing or markup policies.
- Inability of management to improve sales volume, or omission of sales.
- Over valuation of opening stock or under valuation of closing stock
Hence, an analysis of gross profit margin should be carried out in the light
of the information relating to purchasing, mark-ups and markdowns, credit and
collections as well as merchandising policies.