Ratio of Rent to Gross Profit

Organizations often use financial ratios to determine the relationship of certain financial data. In order to understand why an organization would examine the relationship of rent to gross profit margin, you must first understand what gross profit margin is and how it is calculated. Then the importance of examining any piece of financial data, including rent, in relation to this should be clearer.

Gross Profit Margin

Gross profit margin is a financial ratio that examines the relationship of sales to the cost to produce the goods that the organization offers to the public. To calculate gross profit margin, you divide the sales minus the cost of goods sold by sales. Cost of goods sold equates to the direct material and labor costs to produce inventory, or goods, that the company sells. If a company has a 40 percent gross profit margin, then 60 percent of its profits are taken up in the production of inventory items and it has 40 percent remaining to spend on other expenses. However, if it spends this full amount, it will return no profit.

Comparing Rent to Gross Profit Margin

Managerial accounting is a process whereby managers compare the productivity and financial aspects of an organization to determine where they excel and where shortfalls, or room for improvement, exists. Some managers may wish to understand how much of their profits are being eaten away through the payment of rent. This is particularly important if the company is seeking a change to a different size facility due to a lack of efficiency or due to growth.

Interpretation

If a company has a gross profit of 40 percent, totaling $4,000,000, and pays rent of $10,000 per month for its office and warehouse space, then its rent-to-gross-profit ratio is 3 percent per year (($10,000 x 12)/$4,000,000). This means that 3 percent of the profits earned from the sale of goods is taken up by the rent that the company pays for that year.

Operating Ratio

Rent is a part of the operating expenses of an organization. Another important financial ratio that many organizations use to help determine financial health is the operating ratio. To calculate the operating ratio, add the cost of goods sold to the operating expenses and divide by the sales for a year. The value that remains equates to the percentage of revenues that the costs to produce inventory and all operating expenses eats up. Subtracting this from 100 will give you the percentage of profits that the organization earns from operations, before taking into account any revenues or expenses associated with financing or investments.

References

• MetMBA: Financial Ratios
• "Managerial Accounting"; Ray Garrison, et al.; 2006
• Accounting for Management: Operating Ratio