Gross profit ratio is the ratio that shows the total amount of profit that will be earned by a company by selling its products and services. The gross profit ratio is the ratio that shows the total profit before subtracting administrative expenses, operational expense and other expenses from the gross profit. This ratio measures the ability of a business to produce and sell product in a cost effective and efficient manner.
There are two approaches of calculating a gross profit ratio. The first approach is the simple where the cost of direct labor, material cost and cost of overheads is added to form total costs. The total costs are them subtracted from the total sales and the figure is divided with the total sales figure to get the gross profit ratio. The formula of gross profit ratio can be shown as under:-
Gross Profit Ratio = Sales – (Cost of labor+ cost of materials+ cost of overheads)/ Total Sales
Another approach to calculate gross profit ratio is that only the direct materials cost is subtracted from the total sales and the figure is divided with total sales. The formula of this approach can be shown as under:-
Gross Profit Ratio = Sales – Material Cost/ Sales
Gross profit ratio helps the management to take decisions regarding the profitable and unprofitable products and help a business in tracking trend line that which products are performing well in the market and helping in increasing the gross profit of a company.
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