The gross profit ratio shows the proportion of profits generated by the sale of products or services, before selling and administrative expenses. It is used to examine the ability of a business to create sellable products in a cost-effective manner. The ratio is of some importance, especially when tracked on a trend line, to see if a business can continue to provide products to the marketplace for which customers are willing to pay a reasonable price. There is no optimum ratio amount; it can vary substantially by industry.
The gross margin ratio can be measured in two ways. One is to combine the costs of direct material, direct labor, and overhead, subtract them from sales, and divide the result by sales. This is the more comprehensive approach. The formula is:
(Sales – (Direct materials + Direct Labor + Overhead)) ÷ Sales
However, this first method includes a number of fixed costs. A more restrictive version of the formula is to only include direct materials, which may be the only truly variable element of the cost of goods sold. The formula then becomes:
(Sales – Direct materials) ÷ Sales
The second method presents a more accurate view of the margin generated on each individual sale, irrespective of fixed costs. It is also known as the contribution margin ratio.
Gross Profit Ratio Example
Quest Adventure Gear has been suffering declining net profits for several years, so a financial analyst investigates the reason for the change. She discovers that the costs of direct materials and direct labor have not changed significantly as a percentage of sales. However, she notes that the company opened a new production facility three years ago to accommodate increased sales volume, but that sales flattened shortly thereafter. The result has been increased factory overhead costs associated with the new facility, without a sufficient amount of offsetting sales to maintain an adequate profit level.
Based on this analysis, management decides to shutter the new facility, which will result in a 10% decline in sales, but also a 30% increase in gross profit, since so much of the cost of goods sold will be eliminated.