The gross margin ratio is the proportion of each sales dollar remaining after a seller has accounted for the cost of the goods or services provided to a buyer. To calculate this ratio, divide gross profits by net sales. For example, a seller ships goods to a customer and bills the customer $10,000, while also charging the $3,000 cost of the shipped goods to expense. The result is a gross profit of $7,000, for which the gross margin ratio is:
$7,000 Gross profit
$10,000 Net price
= 70% Gross margin ratio
The managers of a business should maintain a close watch over the gross margin ratio, since even a small decline can signal a drop in the overall profits of the business. A further concern is that the costs that go into the calculation of net price can include some fixed costs, such as factory overhead. When this is the case, the gross profit margin will be quite small (or non-existent) when sales are low, since the fixed costs must be covered. As sales volume increases, the fixed cost component is fully covered, leaving more sales to flow through as profit. Thus, the gross margin ratio is more likely to be low when sales volume is low, and increases as a proportion of sales as the unit volume increases. This effect is less evident when the fixed cost component is quite low.
The gross margin ratio is also known as the gross profit ratio.