GPP Ratio

The Gross Profit Percentage (GPP) is a ratio that can be derived from an income statement and reveals the profit left over from operations after all variable costs have been subtracted from revenues. It can be used for determining Operating Performance, because it shows the production efficiency in relation to the prices and unit volumes at which products or services are sold.

Comparison of the ratio provides the most meaningful information. For example:

• Comparing the GPP ratio to an industry average (ensure the method used of calculating the industry ratio is the same). This provides an indication of whether the company is performing better or worse than the industry as a whole. The comparison is useful when obtaining a preliminary knowledge of the company's business.

• Comparing the GPP between different divisions within an entity. This comparison provides an indication of which divisions may require further investigation. The comparison is useful when obtaining a detailed knowledge of the company's business.

• Comparing the GPP over time. For example comparing this year with last year. An increase in the ratio over the previous year may be an indication that cost of sales is understated (including, for example, an overstatement of closing inventory) or that revenue is overstated; a decrease may indicate that cost of sales is overstated or that gross revenue is understated. (Where monthly figures are available, an examination of the ratio for the last two months of the financial year could assist in highlighting any adjustments made to revenue and cost of sales at year end.) In many instances, however, a change in the ratio is due to a change in production methods, product mix, or some other legitimate reason.

A common GPP ratio calculation goes as follows: Add together the costs of overhead, direct materials and direct labor; subtract the total from revenue; and then divide the result by revenue. A problem with this approach is that many of the production costs are not truly variable.

In order to avoid this, an alternate calculation formula only includes direct materials in the formula, shifting the other production costs into operational and administrative costs. This obviously yields a higher gross margin percentage.

Compare with Gross Profit Percentage:  Operating Profit Percentage

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