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Gross Profit Ratio

This ratio shows the relationship between the gross profit to ent sales (or turnover) and is generally expressed in percentage. It is calculated as under:

Gross Profit Ratio = [Gross Profit/Net Sales] x 100

Components: This ratio is based on net sales and gross profit. Net sales are arrived at after deducting sales returns from the total amount of cash and credit sales. Gross profit is the excess of sales over the cost of the goods sold which includes all expenses directly connected with concerns, the cost of goods sold would also include all manufacturing expenses directly related to the quantity produced, e.g., wages, power, freight etc. It is, therefore, clear that operating expenses to help sales are not included.

Significance and interpretation.
The gross profit ratio indicates the relationship between every rupee of sales and the profit made on that amount of sales . It helps the management to know as to what margin of the profit is left to cover indirect expense. Under normal conditions, the gross profit ratio should show little change from year to tear. As a matter of policy, the business can continue its operations only if the gross profit or gross margin absorbs the indirect expenses and leaves a reasonable income for the owner(s). An increase in gross profit ratio may be on account of following factors: (i) The sale price of the goods may increase without an increase in the cost of the goods sold. (ii) A reduction in cost of the goods sold accompanied by comparatively lower reduction in the sale price e.g., cost may be deducted by 5 per cent while sales price may go down by 2 per cent. (iv) The absence of expenses on purchases since the same might have been writes of completely in the previous tear. (v) Sales might be inflated in other ways too, e.g., goods sent on consignment included in sales as well as stock-on-hand. (vi) The change in the method of valuation of the closing stock so that it is clued at prices which were too high. On the other hand, a decrease in the ratio, compared, of course, with the previous tear, may be due to following factors : (i) A decrease in the sale price of the goods sold without corresponding decrease in their costs. (ii) The expenses on purchases incurred last year but recorded this year. (iv) Misappropriation of stock at the end. (v) The rise in wages and other direct costs of production. (vi) The understatement of closing stock due to changes in the method of valuation. (vii) The goods purchased for the personal use of owner(s) included in the purchases of the business.
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