Gross Profit Ratio - AccountingTools

Top

Newsletter Sign Up

Home >> Metrics Summary

Gross Profit Ratio | Gross Profit Equation

Description: The gross profit percentage is one of the most important measurements derived from the income statement. It reveals the profit left over from operations after all variable costs have been subtracted from revenues. In essence, it reveals the efficiency of the production process in relation to the prices and unit volumes at which products are sold.

Formula: There are two way to measure the gross margin ratio. The most common approach is to add together the costs of overhead, direct materials, and direct labor, subtract them from revenue, and then divide the result by revenue. This approach takes into account all costs that can be reasonably associated with the production process. The formula is as follows:

Revenue – (Overhead + Direct Materials + Direct Labor)
Revenue

The trouble with this approach is that many of the production costs are not truly variable. Under a much more strictly defined view of variable costs, only direct materials should be included in the formula, since this is the only cost that truly changes in lock-step with changes in revenue. All other production costs are then shifted into other operational and administrative costs, which typically yields a very high gross margin percentage. The formula is as follows:

Revenue – Direct Materials
Revenue

Example: The Spanish Tile Company bases its sales quoting system on the gross margin assigned to its products – prices quoted must have a gross margin of at least 25% in order to cover administrative costs and create a modest profit. Recently, the Iberian Tile Company has been taking business away from the Spanish Tile Company through more aggressive pricing. Investigation of its competitor’s quoting practices reveals that it uses an alternative gross margin model that uses only direct material costs as a deduction from revenues. This means that its competitor is always in a position to offer lower prices, since it does not incorporate direct labor and overhead costs into its pricing model. The Iberian Tile Company is in danger of quoting excessively low prices if it continues to use its gross margin model, so it focuses on how prospective sales will impact its bottleneck operation, which is the tile kiln. If a prospective sale requires a great deal of kiln time, then it is charged a much higher price than other quotes that do not use as much of this valuable resource. As a result of this survey, the Spanish Tile Company realizes that its competitor has a more precise and aggressive quoting model that will likely result in more lost sales in the future.

Cautions: As was hinted at in the example, a company can incorrectly assume that all of the costs used to calculate the gross margin are variable. This is not at all true; direct materials are frequently the only completely variable costs. Consequently, changes in sales volume will generally result in a different gross margin percentage, since some of the costs will vary with the sales volume and others (e.g., direct labor and overhead) will be fixed.