The gross margin ratio is computed by dividing the company's gross profit dollars by its net sales dollars.
To illustrate the gross margin ratio, let's assume that a company has net sales of $800,000 and its cost of goods sold is $600,000. This means its gross profit is $200,000 (net sales of $800,000 minus its cost of goods sold of $600,000) and its gross margin ratio is 25% (gross profit of $200,000 divided by net sales of $800,000).
A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.
Since gross margin ratios vary between industries, you should compare your company's gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. For example, your company may use LIFO while most companies in your industry use FIFO. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company's gross margin ratio should be larger than your industry's in order to cover the higher selling and administrative expenses.
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