Which of the following describes how to compute the gross profit rate

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.

Table of contents

Gross Profit Ratio Formula

Let us see how to calculate 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.

Gross Profit = Net Sales – Cost of Goods Sold

To obtain gross profit using the above equation, we need to find 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.’

Net Sales = Sales – Return InwardsReturn InwardsReturn Inward, also known as sales return, refers to the goods returned to the business entity when the customers find that the goods delivered did not meet their expectations and, therefore, unsatisfactory.read more

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 gross profit ratio as follows: –

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

(Usually expressed in the form of a percentage)

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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 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 stockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more, i.e., inventory at the end of the period for computing the ratio
• Direct Expenses Incurred.

As we can see, one can pick up all these amounts from the trading account.

Gross Profit Ratio Examples

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

You can download this Gross Profit Ratio Excel Template here – 

ParticularsAmount ($)ParticularsAmount ($)Opening stock35,000Closing Stock15,000Sales200,000Sales Returns20,000Purchase80,000Purchase Returns6,500

#1 – Net Sales

#2 – Cost of Goods Sold (COGS)

#3 – Gross Profit

Finally,

#4 – Gross Profit Ratio Formula

Let us now move on to the significance and implications of the gross profit ratio.

Advantages

• By comparing net sales Net Sales Net sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.read more with the company’s gross profit, the gross profit ratio will enable the users to know the profit margin that the company is earning from the trading and manufacturing activity.
• It determines how much the company makes more than the amount it has to pay for its operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.
• It helps in inter-firm comparison of the results of trading activity.
• Gross profit tells how a company is doing better or worse than its competitors because the higher the efficiency, the higher the gross profit.
• It determines the edge the company has in the market.
• Comparing the gross profit ratio trend over the years helps define the company’s growth rate.
• This margin allows for creating budgets and forecastsBudgets And ForecastsWhile Budgeting refers to planning the business revenues & expenditures for a specified period, Forecasting means predicting the future outcomes by analyzing historical & present trends. read more.

Limitations

• It does not consider the company’s expenses usually charged to the profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more.
• It is only a passive indicator of the company’s overall status. For example, a company may have a positive gross profit margin. Still, when all other expenses All Other ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more reduce, the resultant profit might be quite less, or sometimes, the company may be running in losses. So, the gross profit percentageGross Profit PercentageGross profit percentage is used by the management, investors, and financial analysts to know the economic health and profitability of the company after accounting for the cost of sales. Gross profit percentage formula = Gross profit / Total sales * 100% read more is not a metric on which the entire profitability of the companyProfitability Of The CompanyProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more can be measured or judged.

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: –

• The opening stockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period's closing stock, valued in accordance with appropriate accounting standards based on the nature of the business.read more is understated, or the value of the closing stock is overstated.
• There is an increase in the selling price of the goods without a corresponding increase in the cost of goods sold.
• Similarly, there is a decrease in the cost of goods sold without a corresponding reduction in the selling price.
• There must have been errors while recording the purchases or sales figures. For example, the buys might have been omitted, or sales figures might have been recorded more than the actual sales, i.e., boosted.

Suppose the gross profit trend analysis indicates a decrease in the percentageDecrease In The PercentageDecrease Percentage is used to determine the decrease in two values (final value and initial value) in percentage terms and according to the formula the initial value is subtracted from the final value and the resultant is divided by the initial value and multiplied by 100 to derive the decrease percentage.read more. In that case, 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 reduction in the cost of goods sold.
• Similarly, 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. For example, sales might have been omitted, or purchase figures might have been recorded more than the actual sales, 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 company’s net sales in a manner that what portion of the net sales is achieved as the company’s gross profit. 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 company’s overall functioning. The net profit ratio would be more useful because it considers all other expenses, which we shall learn about in another article.

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