Gross Profit Percentage – Meaning, Example, Advantages and more

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.

Cost of goods sold is the cost incurred in the manufacturing of the products sold. It includes all the direct costs such as labour cost, material cost etc. that forms the production cost of goods and service. It does not take into accounts all the indirect expenses such as selling expenses, distribution expenses and marketing costs etc.

Note: The cost of manufacturing of unsold goods is not taken into account for the calculation of gross profit. And unsold goods are shown as the closing stock, a part of the current assets of the firm.

 The formula for GP calculation:

 GROSS PROFIT=  

SALES – COST OF GOODS SOLD

The formula for GP Percentage Calculation

Gross Profit / Sales *100

Example of GP Margin Calculation:

Mr Rahul Jain has a manufacturing company named A. He provides you following figures related to the year 2019.

Opening stock   25,000
Purchase3,00,000
Closing stock   15,000
Sales 400,000
Direct cost   20,000

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:

70,000/ 400,000 x 100 = 17.5%

Hence, the gross profit percentage of Mr Rahul’s firm id 17.5 %

Gross Profit Percentage

Evaluation of Gross Profit Margin

GP percentage is useful metrics that provide valuable information about the financial health of the company. 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, then your business operation is working efficiently. If it is not goods in comparison to your competitors, then it is warning to observe the components of gross profit – sales, price and manufacturing cost.

Factors affecting the gross profit margin:

Gross profit is the excess of sales over cost of goods sold. 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- labour, material etc. forms a significant part of the cost of production has an impact on the profit.
  • Change in the components of product and services: Some companies deal with customized products that are specific to the customer’s requirements. So, this results in a change in parts of product and service. It will affect both the cost and profits of the firm.
  • Change in the method of inventory valuation: The change in the practice of inventory valuation have an impact on gross profit. The use of FIFO (First In First Out) method use inventory purchased first in the production process. Thus cheap materials used in the current period. But when a firm changes it to LIFO method (Last in last out) which considers recent purchases, it results in higher material cost and decreases the profit.
  • Change in the output level: The cost and profit differ according to the volume of production because the companies set a price in line with the cost and market condition.
  • Fluctuation in Sales: External and Internal factors have bearings in both the volume and price of sales. Example of external factors is economic health, market scenarios, natural elements such as floods, natural disaster etc. Examples of internal factors are marketing cost, pricing, payment option etc.

All these factors have a significant effect on the gross profit of a company.

Advantage of Gross Profit Margin

  1. Simple and effective indicator: It is easy to calculate and indicates about the cost efficiency, financial health of the company, periodic review of company direct cost etc.
  2. Base calculation: It sets as the base for calculation of other profit ratios – Net profit or operating profit, profit before tax and profit after tax.
  3. Price control: It acts as a guideline for the companies in adjusting the price to earn maximum profit.
  4. Set standards: It is a useful tool for a company to measure its performance with that of 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 cost such as salaries, rent, electricity charges and advertisement expense 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 profitability of the firm and, ignores other factors such as an increase in the cost of production to secure a supplier or decrease in the selling price to increase market share etc.
  • Gross profit may produce misleading figures of profit. Because here 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 in the calculation of the contribution margin for cost-volume related decisions. It is calculated by deducting all the fixed cost from gross profit percentage calculation.

 

 

 

Last updated on : July 22nd, 2020
What’s your view on this? Share it in comments below.

Leave a Reply