What is the Gross Profit Percentage?
Gross profit (GP) percentage is a measure of a firm’s profitability at a gross level. It is expressed in terms of the percentage of gross profit to the sales or revenue of a company. The gross profit is the difference between sales and the cost of goods sold (COGS). The GP percentage is also known as gross profit margin. GP balance is brought forward to the credit side of the profit and loss statement.
The cost of goods sold is the cost incurred in the manufacturing of the products sold. It includes all the direct costs, such as labor cost, material cost, etc., that form the production cost of goods and services. It does not take into account all the indirect expenses such as selling expenses, distribution expenses, marketing costs, etc.
- What is the Gross Profit Percentage?
- Formula for GP Calculation
- Formula for GP Percentage Calculation
- Example of GP Margin Calculation
- Evaluation of Gross Profit Margin
- Factors Affecting Gross Profit Margin
- Advantage of Gross Profit Margin
- Disadvantages of Gross Profit Margin
Note: The cost of manufacturing unsold goods is not taken into account in the calculation of gross profit. And unsold goods are shown as the closing stock, a part of the firm’s current assets.
Formula for GP Calculation
|Gross Profit = Net Sales – Cost of Goods Sold|
Formula for GP Percentage Calculation
|Gross Profit / Sales *100|
You can also use Gross Profit Calculator
Example of GP Margin Calculation
Mr. Rahul Jain has a manufacturing company named A. He provides you following figures related to the year 2019.
To calculate the gross profit of Company A, we will first calculate the cost of goods sold
COGS = Opening Stock +Purchase+ direct expenses – Closing stock.
= 25,000+300,000+20,000 -15,000=330,000
Now we know Sales is 400,000
So, Gross profit = 400,000-330,000= 70,000
And Gross profit Percentage:
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
70,000/ 400,000 x 100 = 17.5%
Hence, the gross profit percentage of Mr. Rahul’s firm is 17.5 %
Refer to GROSS PROFIT MARGIN to learn its uses and interpretation.
Evaluation of Gross Profit Margin
GP percentage is a useful metric that provides valuable information about the company’s financial health. A stable GPP indicates the proper functioning of a firm. It also tells whether a company has earned any excess of its direct cost. It facilitates the comparison of your firm with your competitors by analyzing its gross profit margin. If the GPP is better than that of the competitors, your business operation is working efficiently. If it is not goods in comparison to your competitors, then it is a warning to observe the components of gross profit – sales, price, and manufacturing cost.
Refer HOW TO ANALYZE & MAXIMIZE GP MARGIN? for more detail.
Factors Affecting Gross Profit Margin
Gross profit is the excess of sales over the COGS. So, any change in the gross profit margin is due to the following possible causes:
Change in Price of Factors of Production
Change in the number of elements of production- labor, material, etc. forms a significant part of the cost of production and has an impact on the profit.
Fluctuation in Sales
External and internal factors have bearings in both the volume and price of sales. Examples of external factors are economic health, market scenarios, natural elements such as floods, natural disasters, etc. Examples of internal factors are marketing cost, pricing, payment option, etc.
Change in Components of Products & Services
Some companies deal with customized products that are specific to the customer’s requirements. So, this results in a change in parts of the product and service. It will affect both the cost and profits of the firm.
Change in Method of Inventory Valuation
The change in the practice of inventory valuation has an impact on gross profit. The use of the FIFO (First In First Out) method use inventory purchased first in the production process. Thus cheap materials are used in the current period. But when a firm changes it to the LIFO method (Last in, last out), which considers recent purchases, it results in higher material costs and decreases the profit.
Change in Output Level
The cost and profit differ according to the production volume because the companies set a price in line with the cost and market condition.
All these factors have a significant effect on a company’s gross profit.
Advantage of Gross Profit Margin
- Simple and effective indicator: It is easy to calculate and indicates the cost efficiency, financial health of the company, periodic review of company direct cost, etc.
- Base calculation: It sets as the base for calculating other profit ratios – Net profit or operating profit, profit before tax, and profit after tax.
- Price control: It acts as a guideline for the companies in adjusting the price to earn maximum profit.
- Set standards: It is a useful tool for a company to measure its performance with industry competitors.
Disadvantages of Gross Profit Margin
- It does not give an accurate picture of a company’s operational efficiency because it excludes all the indirect costs such as salaries, rent, electricity charges, advertisement expenses, etc.
- Gross profit margin is not always a good benchmark for industry comparisons as there is variance in the cost structure and profit determination between the industries.
- It measures only the firm’s profitability and ignores other factors such as an increase in the cost of production to secure a supplier or a decrease in the selling price to increase market share etc.
- Gross profit may produce misleading figures of profit. Because here, the production cost is only considered, which further depends on a stock valuation methodology. For example, the cost of materials may vary because of the inventory valuation method such as LIFO, FIFO, and weighted average method.
GPP is also used to calculate the contribution margin for cost-volume-related decisions. It is calculated by deducting all the fixed costs from the gross profit percentage calculation.
To know more about such other types, read PROFITABILITY RATIOS.
Quiz on Gross Profit Percentage
This quiz will help you to take a quick test of what you have read here.