Payroll is usually one of the biggest expenses in a business, which is why it must be monitored and controlled constantly to maximize profitability. Gross profit pays for all expenditures, and whatever is left after deducting expenses from gross profit becomes net profit. Each expense item gets a share of gross profit, and the bigger each expense, the less that is left for net profits. Payroll-to-gross profit ratio is an accounting tool you can use to measure how much gross profit is used to pay your workers.
Measurement of wages as a percentage of gross profit is the primary objective of this ratio. Accountants and financial managers usually compute this ratio so they can compare the efficiency of your company's workers with the workers of peer companies, competitors and your own historical records. Doing so allows them to see trend changes and differences that can be used to determine the efficiency of your work force.
Dividing gross wages by gross profit will yield the payroll-to-gross profit ratio. Multiplying the ratio by 100 will convert it into percentage. Gross wages do not include deductions for employee taxes, advances and contributions to employee benefit programs. Gross profit is the result of deducting cost of goods sold from net sales. These figures are found in an income statement.
Assume that your company's operations for one year result in a total gross profit of $1 million and a gross payroll of $300,000. Dividing the gross payroll of $300,000 by the gross profit of $1 million will yield a payroll-to-gross profit ratio of 30 percent. This means that 30 percent of the gross profit generated for that year was used to pay for wages of employees.
The ratio becomes more meaningful when it is compared against other payroll-to-gross profit ratios. The lower your ratio, the more efficiently you are using your labor force. A ratio lower than industry average or lower than your competitor's would mean that your workers are more efficient than your competitor's workers. Plotting the ratio periodically will show you its trend. A decreasing trend indicates improving labor efficiency, while an increasing one can mean that employee performance is deteriorating.