What is the Gross Profit Ratio?
The gross profit ratio refers to the relationship between the revenue from operations with the gross profit earned by an enterprise. The difference between the sales of an enterprise and the cost of goods sold results in the company's gross profit ratio. The gross profit ratio is an example of a profitability ratio. This article will discuss the gross profit ratio, the gross profit ratio formula, the objectives and significance of the gross profit ratio, and examples and methods to compute it.
Reason for Increase or Decrease in Gross Profit
The various reasons for the increase and decrease in gross profit are mentioned here as under
The selling price remains constant, and the cost of revenue changes.
The cost of revenue remains constant, and the selling price changes.
Where both costs of revenue and selling price change.
So the above reasons are responsible for the changes in gross profit due to the organisation's profitability changes.
Objectives and Significance of Gross Profit
To determine the efficiency of the business through profitability ratios, the gross profit ratio is used. Through the various operations of purchase, production and selling operations, the gross profit ratio is used. It should be adequate to cover all expenses to generate dividends and build reserves.
Methods for Computation of Gross Profit Ratio
Computation of gross profit ratio and cost and sales are done in different ways for different types of organisations. The gross profit ratio in such a case is computed as a percentage. The revenue from operation in the case of non-finance enterprises is sales minus sales return, whereas, in the case of financial companies, it is interest earned and dividends received through various other means of income.
Gross Profit ratio = Gross profit/Revenue from operations * 100
Where
Solved Gross Profit Ratio Example
Question1: From the following information, calculate the Gross Profit Ratio.
Solution:
Gross Profit ratio = Gross profit/Revenue from operations * 100
For 31st March 2021:
Gross profit ratio= 4000/16000 *100 =25%
For 31st March 2022:
Gross profit ratio= 6000/20000 *100 =30%
Question 2: From the following information, calculate the Gross Profit Ratio.
Revenue From operations: 60000
Gross Profit = 25% on cost
Solution:
Let the Cost be Rs. 100
Gross Profit= Rs 25
Sales=Rs 125
Cost of goods sold=100/125*60000=48000
Gross Profit Ratio = Sales-Cost of goods sold=60000-48000=12000
Gross Profit ratio= Gross profit/Revenue from operations * 100
12000/60000*100=20%
Solved Numerical Problems
1. Calculate Gross Profit Ratio from the following information.
Ans:
Trading Account
Dr
Cr
Gross Profit Ratio= Gross Profit/Revenue from Operations * 100
=358000/850000*100=42.12%
2. From the following information, calculate the Gross Profit Ratio.
Revenue From operations:60000
Gross Profit =25% on cost
Ans: The computation is here as under
Let the Cost be Rs. 100
Gross Profit= Rs 25
Sales=Rs 125
Cost of goods sold=100/125*60000=48000
Gross Profit Ratio = Sales-Cost of goods sold=60000-48000=12000
Gross Profit ratio= Gross profit/Revenue from operations * 100
12000/60000*100=20%
So the gross profit ratio, in this case, is 20%
Summary
Gross profit is the difference between net sales minus cost of goods sold. The ratio may be compared with the industries of similar segments or may be compared with the same firm with different years. Higher gross profit is desired as it leaves higher profitability and vice versa. It also depicts the relationship between revenue from operations and gross profit.
FAQs on Gross Profit Ratio: A Key Profitability Metric
1. What is the formula used to calculate the Gross Profit Ratio as per the CBSE Class 12 syllabus?
The Gross Profit Ratio is calculated using a simple formula that measures the relationship between a company's gross profit and its revenue from operations. The formula is:
Gross Profit Ratio = (Gross Profit / Revenue from Operations) × 100
Here, Gross Profit is calculated as Revenue from Operations minus the Cost of Revenue from Operations (or Cost of Goods Sold).
2. What does the Gross Profit Ratio primarily indicate about a company's performance?
The Gross Profit Ratio is a key profitability metric that indicates how efficiently a company is using its materials and labour to produce and sell its products. A higher ratio suggests that the company has a good handle on its production costs and pricing strategy, leaving more money to cover its other operating and non-operating expenses. It essentially shows the company's profit margin before accounting for administrative, selling, and other costs.
3. How do business transactions like 'Purchase of Stock-in-Trade' affect the Gross Profit Ratio?
This is a common point of confusion. A transaction like the 'Purchase of Stock-in-Trade' will typically have no change on the Gross Profit Ratio. This is because the purchase increases the 'Cost of Revenue from Operations' but also increases the 'Closing Stock' by the same amount. These two effects cancel each other out in the calculation of Gross Profit (Revenue - Cost of Revenue), thus leaving the ratio unchanged, assuming revenue remains constant.
4. What is the fundamental difference between Gross Profit Ratio and Net Profit Ratio?
The key difference lies in the costs they account for.
The Gross Profit Ratio only considers the direct costs of production (Cost of Goods Sold) against revenue. It reflects the profitability of the core manufacturing or trading activity.
The Net Profit Ratio provides a complete picture by considering all expenses, including both operating (like salaries, rent) and non-operating (like interest, taxes) expenses, against revenue. Therefore, it measures the overall profitability of the entire business.
5. Is there an 'ideal' Gross Profit Ratio for a business?
There is no single 'ideal' Gross Profit Ratio that applies to all businesses. It varies significantly across different industries. For example, a software company might have a very high ratio (e.g., 80-90%), while a retail or grocery business might have a much lower one (e.g., 20-30%) due to higher direct costs. The best way to analyse the ratio is to compare it with the company's own past performance and with the ratios of its direct competitors in the same industry.
6. Why might a company with a high Gross Profit Ratio still end up with a low Net Profit Ratio?
This scenario indicates that while the company is efficient at producing its goods or services (high Gross Profit), it struggles with managing its other costs. A high Gross Profit Ratio can be quickly eroded by high operating expenses (such as large marketing budgets, high salaries, or expensive office rent) and significant non-operating expenses (like heavy interest payments on debt). This highlights why analysing only the Gross Profit Ratio is insufficient for assessing overall profitability.
7. What are the main advantages of calculating the Gross Profit Ratio?
Calculating the Gross Profit Ratio offers several advantages for analysis:
Pricing and Cost Control: It helps management assess the effectiveness of their pricing policies and control over production costs.
Trend Analysis: Tracking the ratio over several years helps in identifying positive or negative trends in the company's core operational efficiency.
Inter-firm Comparison: It allows for a comparison of a company's production efficiency with that of its competitors in the same industry.
8. Is the Gross Profit Ratio alone a sufficient indicator of a company's overall financial health?
No, the Gross Profit Ratio is not a sufficient indicator on its own. It provides a valuable but narrow view focused only on production efficiency. A complete assessment of financial health requires analysing it alongside other ratios like the Net Profit Ratio (for overall profitability), Operating Ratio (for operational costs), and various liquidity and solvency ratios to get a holistic picture of the company's performance and stability.
