Profitability - Gross Profit Ratio

What it measures: Profitability (profit margins on goods sold) 

The level of mark-up a firm has on its final output; the difference between COGS and revenue; how much profit is generated from goods sold;

Information drawn from the Income Statement;

Represented as a percentage  

The equation:

Gross Profit / Sales x 100 

What the result means:

The percentage of each $1 of sales that results in Gross Profit.  Higher numbers are better for a firm—meaning that they are able to maximise their profit margins on the goods they sell.

Lower results indicate narrow profit margins, making it difficult for the firm to pay expenses (other costs of doing business) and result in a net profit.  Firms can increase the Gross Profit Ratio by lifting prices (subject to competition) or find cheaper suppliers (subject to availability and quality levels).

Many service firms do not use the Gross Profit Ratio as their COGS are negligible. Gross profit Ratio is highly relevant for retailers and other on-sellers.

Sample Statement:

Gross Profit ($700,000) / Sales $1,400,000) x 100 = 50%

The firm has a Gross Profit Ratio of 50%. This means that half of the firm’s revenue ends up as Gross Profit. This result indicates a strong ability for the firm to generate revenue from the goods it sells (generating $2 of revenue from every $1 of inventory purchases. This may be quite high, subject to industry standards.

How to Improve the Gross Profit Ratio:

• Lift prices

• Sell less for the same price (shrinkflation)

• Change supplier or negotiate better deal with supplier for bulk purchases (economies of scale - but then need to consider Inventory Management)

Gross Profit Ratio is Negatively Impacted by:

• Competition or price wars (forcing prices down squeezes margins)

• Sales Promotion or Price Penetration strategy (lowering prices to gain sales and market share)

• Suppliers lifting their prices (higher COGS)

• Customer buying power (if a big and powerful customer like Woolworths negotiates a lower price to access their shelves)

• Product Life Cycle in decline (price reduction)