Gross Profit And Gross Profit Ratio - 2 Useful Measures Of Profitability

Many business people are confused by the language that careless accountants and other practitioners of bookkeeping and accounting use to describe the "gross profit" and the "gross profit ratio." With clear definitions much good will come to our businesses.

1. Gross Profit (GP) is what measures a company's profitability from the sale of merchandise only; that is, the GP is a gross amount from which no operating expenses have been deducted. Naturally, a good business must strive to have a GP large enough to cover all the operating expenses (also called overhead expenses).

Other careless synonyms are: 'gross profits,' 'gross operating profit.'

The formula is: GP = Net sales - Cost of Goods Sold

2. Gross Profit Ratio (GPR) is a mathematical ratio that we find when we divide the GP by the net sales.

Let's illustrate:
Net Sales....................$350,000
Cost of goods sold........ 150,000
Gross profit................. 200,000

GPR = GP / Net sales
$200,000 / $350,000
GPR = 57.14%

While the GP is a dollar amount ($200,000) of limited significance, the GPR is a mathematical ratio and a more meaningful measure. The ratio gives us the basis for comparison with other businesses in the same industry.

For example: if I own a restaurant and my GPR is 57.14%, I can call my local chamber of commerce, my local library, or the Restaurants Association and ask what the GPR is for other restaurants in my region.

If I learn that other restaurants show a GPR of 60%, then I must get busy and investigate why this is so. Why are my competitors outperforming me? Are my selling prices adequate or should I increase them? Perhaps I am buying my ingredients from a wholesaler who is overcharging me.

Keep in mind that the comparison must be made with other businesses in the same type of industry. As, the old adage goes: we must compare apples to apples. It stands to reason that the GPR for a hardware store or a drugstore will not be comparable.

The GPR is often called 'gross profit rate' and 'gross profit margin.'

From the above discussion we can see that the ratio is a more useful tool than the dollar amount.

Brief Exercise: compute the GPR for the following company

Net Sales....................$850,000
Cost of goods sold........ 425,000
Gross profit................. 425,000

If we keep a close eye on our prices, over which we have much control, and if we buy our ingredients or merchandise at low prices, then we can be sure that our GP will be adequate to cover the operating expenses-and obtain a net profit!

This is the eternal business dance: buy cheap sell dear! (By the way, the answer for the brief exercise is GPR = 50%).