Net sales, gross profit, and the gross margin ratio are calculated by subtracting sales discounts and returns from sales, then subtracting the cost of goods sold from the net sales, and finally dividing the gross profit by net sales. The accounting profit is found by subtracting explicit costs from total revenues. The company with the highest gross margin ratio is seen as having a better performance.
To compute the net sales, gross profit, and gross margin ratio for each company, we will perform the following calculations:
- Net Sales = Sales - Sales Discounts - Sales Returns and Allowances.
- Gross Profit = Net Sales - Cost of Goods Sold.
- Gross Margin Ratio = (Gross Profit / Net Sales) x 100.
For a firm with $1 million sales revenue, spending $600,000 on labor, $150,000 on capital, and $200,000 on materials, the accounting profit is calculated as:
Accounting Profit = Total Revenues - Explicit Costs
Accounting Profit = $1,000,000 - ($600,000 + $150,000 + $200,000)
Accounting Profit = $1,000,000 - $950,000
Accounting Profit = $50,000
The company with the highest gross margin ratio is considered to have the better performance, as it indicates how much of each dollar of sales a company keeps in earnings.