Importance of g.p. ratio

CA. Saurabh Mishra (Practice) (104 Points)

22 March 2013  

Gross profit optimization is a vital area of operation for most of the firms and companies. Gross profit is the actually what left with the firm after paying the cost of the goods sold by the company. It is one of the most important figures for a firm as it helps in determining when a firm is going to reach the break even and what will be the projected profit level beyond the break even point. In order to understand and calculate the profit margins accurately it is important to optimize the gross profit and gross profit margin. The gross profit margin shows the percent of the sales that is remained with the company after paying the direct cost associated with the goods sold. The higher the percentage and the value of the gross profit the more are the number of dollars a company retains on each good sold. For example if we have calculated the gross profit margin from the gross profit and comes to be 50 percent it means that the company will $.50 from each dollar that is generated as a revenue. 


Optimizing and evaluating the gross profit accurately will help a company in avoiding the problems associated with the low price and high production costs of the product. In contrast to this it can help to solve the problems associated with break even and the profit generated after break even. If a company attempts to increase the gross profit by lowering the price to increase the sales volume it will only worsens the conditions so it is very important to calculate the gross profit and pricing with great care.

It is important for the companies to consider the factors that will directly affect the gross profit and pay close consideration to those factors. Companies can use competitor’s data and the average of their particular industry to benchmark the level of gross profit for them. It is very important for a company to understand that factors affecting the gross profit may change during the period of time so they must keep and eye on the rise and fall of each factor.


GROSS profit ratio is the ratio of gross profit to net sales i.e. sales less sales returns. The ratio thus reflects the margin of profit that a concern is able to earn on its trading and manufacturing activity. It is the most commonly calculated ratio. It is employed for inter-firm and inter-firm comparison of trading results.


 Following formula is used to calculated gross profit ratio (GP Ratio):

Gross profit / (Net sales × 100)

Where Gross profit = Net sales - Cost of goods sold

Cost of goods sold = Opening stock + Net purchases + Direct expenses - Closing stock

Net sales = Sales - Returns inwards

Gross profit is what is revealed by the trading account. It results from the difference between net sales and cost of goods sold without taking into account expenses generally charged to the profit and loss account. The larger the gap, the greater is the scope for absorbing various expenses on administration, maintenance, arranging finance, selling and distribution and yet leaving net profit for the proprietors or shareholders.

In case, there is increase in the percentage of gross profit as compared to the previous year, it is indicator of one or more of the following factors.

  • The selling price of the goods has gone up without corresponding increase in the cost of goods sold.
  • The cost of goods sold has gone down without corresponding decrease in the selling price of the goods.
  • Purchases might have been omitted or sales figures might have been inflated.
  • The valuation of the opening stock is lower than what it should be or the valuation of the closing stock is higher than what it should be.
  • In case, there a decrease in the rate of gross profit, it may be due to one or more of the following reasons.
  • There may be decrease in the selling rate of the goods sold without corresponding decrease in the cost of goods sold.
  • There may be increase in the cost of goods sold without corresponding increase in the selling price of the goods sold.
  • There may be omission of sales.
  • Stock at the end may have been under-valued or opening stock may have been over-valued.