Gross profit percentage accounting definition

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Gross profit percentage accounting definition
A gross profit percentage is a common accounting ratio used to analyse profits. (30 % rouge image by Kho from Fotolia.com)

A gross profit percentage is a financial ratio also known as a gross profit margin. This ratio is easy to calculate and is a good measure of a company's efficiency. Investors look for companies with a high gross profit percentage when choosing where to invest their money.

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Gross profit

Gross profit is an accounting term that represents a company's profit before it deducts any of the operating expenses. Gross profit, therefore, is a company's net sales amount minus the cost of the inventory or cost of goods sold. A gross profit amount is used in many financial ratio calculations.

Formula

To calculate a gross profit percentage, the company's gross profit is divided by the company's total revenue. For example, if a company has net sales of £50,00 and the cost of that inventory was £20,000, this leaves a gross profit of £30,000. The gross profit amount of £30,000 is divided by the net sales amount of £50,000, making the gross profit percentage 60 per cent.

Percentage explained

With the above example, the gross profit percentage is calculated at 60 per cent. What this percentage represents is that for every pound a company generates in sales, the company has 60 pence left to cover operating expenses. It also means that for every pound a company generates in sales, 40 pence of that pound was the company's inventory cost.

Operating expenses

With a high gross profit percentage, there is more room for payment of operating expenses. Operating expenses, however, really cut into a company's profit. Companies use the gross profit percentage, as a guide, when maintaining efficiencies within the company. The percentage is used for comparison to prior months or years and is also compared to the industry's average.

Variances

Gross profit percentages if calculated monthly, sometimes experience drastic changes. There are several reasons for this. If the goods the company sold were offered at a reduced price for a certain period of time, this decreases the amount of total revenue which, in turn, decreases the gross profit percentage. If inventory costs increased and selling prices remained the same, the gross profit rate would also decrease. Gross profit percentages are most accurate when calculated and compared yearly.

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