Definition: The Gross Profit Margin Ratio shows how efficiently the company has generated revenues from the sale of its inventories and merchandise. Simply, this ratio measures the amount of profit generated after meeting the direct expenses related to the production of goods and services.
The gross profit is the difference between the revenues generated and the cost of goods sold. This ratio shows the margin left after meeting the manufacturing cost. The manufacturing cost includes the material cost, employee benefits cost, manufacturing expenses, etc.
The gross profit margin ratio measures the efficiency of production and pricing and is very useful for comparing the current gross margins with that of the previous years. Formula to calculate Gross Profit Margin Ratio is:
Gross Profit Margin Ratio = Gross Profit/Net Sales
Where, Gross Profit = Revenues – Cost of goods sold
Higher ratio value shows that the company is selling its inventory and the merchandise at a high-profit percentage, and therefore, higher ratios are more favorable.
Example, Suppose a firm has a net sales of Rs 5,00,00 and its Cost of Goods Sold is Rs 2,00,000. Then the Gross profit will be 3,00,000 (5,00,000-2,00,000) and the Gross profit margin ratio will be:
= 3,00,000/5,00,000 = 0.6 or 60%