How to Calculate Gross Profit Ratio

Understanding the importance of the gross profit ratio is a crucial task for any business owner. Calculating the most appropriate way to use labor and materials will have a long-lasting impact on your organization. This article will discuss what gross profit ratio, its importance, and how to calculate it. 

To reach this valuable piece of information, it requires knowledge of important figures on your company’s sales and its costs. Over the years, calculating gross profit ratio has gained popularity with investors because it provides reliable information.  

But what is it, and how do you do about calculating it?

What is Gross Profit Ratio

The gross profit ratio is a tool that measures the performance and efficiency of your organization. The final number is expressed in percentage form. 

It can be easily done by determining the total sales over a specific period of time and deducting the total costs of the product or services you are selling. 

Your net sales number represents your total gross sales, including all forms of income — rentals, royalties, interests, investments, etc. 

Why is Gross Profit Ratio Important?

The gross profit ratio is used as a tool to gauge if your company has sustainable competitive advantages. It indicates how efficient you are selling your product or services. 

Understanding the amount of capital left after all the expenses show management how much to reinvest in the company. In theory, it gives you an accurate number of how much revenue you can use for other needs. 

Moreover, a high gross profit rate is attractive for investors because it is a sign that the investment will pay off quickly. Conversely, a low or negative ratio will discourage investors. 

A company with a low ratio typically means that it will require restructuring to lower its spending. This is true even if the company has a high revenue. In such a case, any changes to the company’s operation can potentially turn a profitable organization into an unprofitable one. 

Therefore, it is crucial to creating a high gross profit ratio as early as possible. 

Gross Profit Ratio Formula

The formula to calculate your ratio is very simple. 

Gross profit divided by net sales x 100

The gross profit is the cost of goods sold minus the total net sales. 

How to  Calculate Gross Profit Ratio

1. Gather all the information needed

To properly calculate the ratio, you will need to acquire some financial metrics:

• Purchases
• Cash sales
• Credit sales
• Sales returns
• Direct expenses
• Current inventory

2. Calculate Net Sales

After determining the Cost of goods sold (COGS). It can be calculated as follows

(Beginning inventory + Additional inventory costs) – ending inventory

For instance, if you make soap, and it costs $2 each to produce. At the beginning of January, your inventory showed 100 pieces. It would be a total of $200 in inventory (100 x $2 = $200). 

During the month you made another 300 or $600 of inventory (300 x $2 = $600). You sold 350 pieces or $700. Your calculation would look something like this:

($200 + $600) – $100 = $700 COGS

Now that you have the COGS, you need to calculate the net sales. You simply add the credit and cash sales and subtract the sales return. 

Finally, the gross profit is calculated by subtracting the COGS from the net sales. 

Apply the Gross Profit Ratio Formula

The gross profit ratio is calculated by dividing the gross profit by the net sales and multiply by 100. 

Let’s say that you own Duke’s Soap and your company looks something like this:

Total Sales: $75,000

COGS: $31,000

Your first step is to find the profit:

$75,000 – $31,000 = $44,000 profit

Now, you have to use the two elements with the formula. 

$44,000/$75,000 = 0.59

Finally, to get the correct percentage, you simply multiply by 100

0.59 x 100 = 59%

Duke’s Soap has a gross profit ratio of 59%.