Gross Profit Percentage – GP ratio is the profitability ratio that shows the connection between the cost of goods sold and the sales of an organization.
The measurement of a firm’s profitability at the gross level is called Gross Profit. The difference between the sales and cost of goods sold is GP it is kept on the credit side of the Profit and Loss account.
How to Calculate Gross Profit Percentage?
The remaining amount covering COGS is used to service other operating expenses, general, administration, marketing, interest, etc. Simply the expenses which are indirectly related to the production appear in the income statement. So higher gross profit means the company can easily pay off the operating expenses.
Steps to find the Gross Profit Percentage Formula
- Note down the total sales of the company it can be taken from the income statement.
- Take the Cost of Goods sold by adding the direct cost of manufacturing like raw material, labor, wages, etc.
- Now deduct the COGS from the total sales amount.
- GP= Total sales – COGS (Cost of Goods Sold)
- Now divide the Gross Profit by total sales and multiply it by 100.
Why do we Calculate the GP Ratio?
GP ratio helps the customers to know the margin of profit that a company is earning.
- Comparison with competitors
It helps a business on how to compare with its competitors; the company with a higher GP ratio has a large gross profit.
- Basic calculation
GP ratio is the base for all types of profit ratios Net profit/ operating profit, Profit after tax, etc.
- Helps to control the price
It works like a guideline for the companies in adjusting the price to earn profits.
- Set standards
It acts like a tool for a company to know its performance according to the standards of a company.
Factors included in Cost of Goods Sold
The direct cost and direct labor cost incurred on the production of goods. It is directly tied to the production of goods including the following expenses.
- Raw material and inventory.
- Labour and Wages paid to workers.
- Cost of the machinery and equipment used in production.
- Heat and electricity are used for production in the industry.
- Shipping costs for production.
What is the meaning of Fluctuation in Gross Profit?
The fluctuated gross profit is a sign of poor management practice in a company. In case the fluctuation is justified the business needs to change its business model. If the company decided to change a certain supply the initial investment may be high but it helps to grow the business in the long term.
How to find the Cost of Goods Sold?
The cost of goods sold is based on the inventory costing method used by the business. There are three methods a company can use to record the inventory value.
First in First Out (FIFO)
Last in First Out (LIFO)
Average Cost Method
The products that come in stock first are sold first. It is expected that prices increase over a while so the company uses this method. In this method Cost of Goods Sold remains low. Net Income increases due to the Cost of Goods Sold remains low.
The goods added to the inventory are sold first. When the price rises the goods with higher costs are sold first. As a result of it, the cost of goods sold remains high so net profit tends to decrease.
- Average Cost Method
The average price of the stock is taken so the date of the purchase of goods is not considered. The cost of goods sold doesn’t have an impact on the extreme cost.
What Factors Affect Gross Profit Percentage?
- Inventory cost
It depends on the organization how they will calculate inventory like in the FIFO method GP increases in LIFO the GP decreases. To improve GP, some companies leave their operating expenses.
- Labor cost
An increase in labor cost increases the cost of goods sold as a result GP decreases. Poor HR management is the key point to the increased cost to the company.
- Changes in sales
A sudden decrease or increase in sales affects the GP ratio. Internal and external factors influence sales. External factors are responsible for changes in sales. The external factors are economic, market stability, demand, natural factors, etc. The internal factors include price, payment option, etc.
In some cases when the cost of goods sold is high a customer can earn profit by charging fundamental expenses to its customers.