Gross Profit Margin Ratio Definition - Formula - Importance - Example - Analysis

Firstly, we try to know the question, “What is Gross Profit Margin”. 

Basically, when we deduct our Cost of Sales from Net Sales, then we get the amount of Gross Profit. To show the performance how much we generate profit out of cost of sales.

It shows the relationship of Gross Profit to Net Sales. It is expressed in percentage (%).

How To Find Gross Profit Margin

We use following Gross Profit Margin Formula to calculate Gross Profit Margin: 

  

Gross Profit / Net Sales x 100

For Example, for the month of November Gross Profit is Rs. 300000 and Net Sales is Rs. 500000, then by applying the formula, Gross Profit Margin for the November is: 

300000 / 500000 x 100 = 60% 

Now, let say that for the month of December, Gross Profit increased to Rs. 400000 and Net Sales also increased to Rs. 700000, then Gross Profit Margin is: 

400000 / 700000 x 100 = 57%

  

Analysis of Gross Profit Margin Ratio

1. As Gross Profit Margin is decreased from 60% to 57%, so, we can say that there is inverse relationship between Gross Profit and Net Sales and hence to increase Gross Profit Margin, more valuable and quality input should be utilized to minimize the cost and maximize the Profit. That is why, this ratio is also called Profitability Ratio as it shows the profitability of the company by utilizing efficient use of resources at minimum cost but the quality should be retained at every cost.

 

2. From the example, it is also clear that the utilization of cost of sales efficiently can increase the Gross Profit Margin. 

For the month of November, Cost of Sales = 500000 - 300000 = 200000 while for the month of December, Cost of Sales = 7000000 - 400000 = 300000 and hence due to the increase in the Cost of Sales, the Gross Profit Margin is declined as compare to previous month and it is 3% lesser than the month of November.

  

You may also be interested in Gross Profit VS Gross Margin 

  

  

Importance / Significance of Gross Profit Margin

1. Gross Profit Margin helps the entrepreneurs in measuring the profitability performance of the resources of the business.  

2. The company minimizes the cost of productions and improve the quality of products and services in the manufacturing department. 

  

So, the Gross Profit Margin is very important for the profitability performance of the business resources and helps the entrepreneurs in meeting the financial objectives of the business in the long run.

In addition to simple or regular or unadjusted gross margin ratio, the company is also interested in the calculation of adjusted gross margin ratio which considers carrying costs of inventory in determining the more accurate profitability of company's products.

Adjusted Gross Margin  =  {(Gross Profit - Carrying Costs / Net Sales)} X 100

Example: If the company has gross profit for the accounting period is $20,00000 and net sales for the period is $70,00000. The carrying cost is $300,000. What is the gross margin and adjusted gross margin?

Gross Margin  =  Gross Profit / Net Sales X 100 = 29%

Adjusted Gross Margin = {(Gross Profit - Carrying Costs / Net Sales)} X 100 = 24%

From the above example, we analysis that adjusted gross tells us better profitability of a company products. Also, it is possible that two products give the same gross profits but one product is more expensive than the other more due to the inclusion of carrying costs and hence as a result, the company can identify those factors which increases expenses by overcoming unimprovements.