Gross Profit Ratio

It is the quotient that expresses the relationship between gross profit and sales or cost of goods sold. Therefore, the gross profit can either be expressed in terms of sales (net) or cost of goods sold (COS).

If expressed on sales, it is referred to gross profit margin

Gross Profit Margin=

Example 1

Double Tech organization provided you with the following information for the year ended 31st/03/2020

Amt. \$

Sales                                                              250,000

Opening inventory                                            30,000

Purchases                                                        50,000

Closing inventory                                             10,000

Required

Determine the profit margin and interpret the results thereof

Solution

Interpretation

For every sales made of \$25, the organization generates gross profit of \$18

If expressed on cost of goods sold, it is referred to gross profit mark up

Example 2

Assume the example of Double Tech organization provided you with the same information for the year ended 31st/03/2020

Amt. \$

Sales                                                                250,000

Opening inventory                                              30,000

Purchases                                                          50,000

Closing inventory                                               10,000

Required

Determine the profit mark-up and interpret the results thereof

Solution

Interpretation

For every sales made of \$7, the organization generates gross profit of \$18

Relationship between Gross Profit Margin and Gross Profit Mark-up

The general association is as follows;

Scenario “a”

Example 1

Scenario “b”

Example 2

CONCLUSION-Therefore, given gross profit margin, it is possible to switch from gross profit margin ratio to gross profit mark-up. Equally, given gross profit mark-up, it is possible to switch from gross profit mark-up to gross profit margin.

NB: Generally, the gross profit ratio in most cases is high for we expect it to cover other operational and financial expenses

Applicability of Gross profit ratio in Decision Making by Management

Gross profit ratio which can either be expressed in terms of sales or cost of sales has a role to play in management decision-making spheres

Denominator factor

One; sales being the denominator, in the expression of  Gross Profit/Net Sales,the management needs to interrogate factors such as pricing policy to ensure that the organization’s products remain competitive in the market for failure to do this will adversely affect the gross profit level in an adverse manner and by extension negatively affect the net profit

On the same breath, the sales element is usually net of any returns inwards. Return inwards results to decline in the level of the sales value which adversely affect the gross profit. Therefore, the management need to ensure that no anomalies resulting to return of sales already made. This can be achieved by;

1. Clean delivery policy; Ensuring during delivery of the sold goods, the supply is as per the set standards of the organization and as per the customer’s preference or Terms of Reference (TOR).
2. Sales promotion policy; Ensure the products of the organization are ever in the market domain for the assurance of marketability and increased sales levels
3. Pricing policy; ensure the pricing policy does not scare customers from the product for this can lead to loss of market share

Numerator factor

In the expression Gross Profit/Net Sales,

, gross profit is the numerator and it is composed of sales less cost of goods sold. Cost of goods sold entails opening and closing inventory, purchases, carriage inwards, and returns outward

Under these aspects, the management can apply the formula to

1. Establish inventory policy which minimizes existence of slow moving inventory for it can negatively affect the gross profit of the business. Also, the management need to establish an inventory system to ensure that carriage inwards cost are minimal and this can be achieved by using own transport means
2. Establish purchasing policy that is favorable to the business-the management should ensure that goods purchased are of right quality to avoid wastage especially in with manufacturing firms or returns outwards which reduce chances of maximizing sales. This is because if some goods are returned then it means the firm may in the short run not be able to meet the demand levels.

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.