Gross profit: Testing your bottom line for accuracy
By Cora M. Barnhart • Bankrate.com

Sept. 9, 1999 -- A business owner who has a handle on his firm's revenues and costs is ready to calculate its gross profit.

This tax tip suggests individual items a taxpayer should double-check on a tax return before figuring the gross profit. It also explains an easy way to test this figure for accuracy.

An easy two-step
Calculating gross profit involves all of two steps. First, subtract all returns and allowances from gross receipts. This step adjusts total receipts, or revenues, for any cash and credit refunds made to customers, as well as rebates and other allowances off the original sales price.

If your business sells services instead of goods, stop here. However, if your revenues rely on selling merchandise, you will also need to subtract the cost of goods sold from gross receipts. Determine this by adjusting the inventory value at the beginning of the year for any later additions and reductions.

Do a double take
While the process for calculating gross profit is straightforward, the end result can only be as accurate as the items used to calculate it. The first item you should check is gross receipts. Daily records should balance with actual cash and credit receipts for that day. Cash registers conveniently track receipts. Taxpayers also find it helpful to keep a separate bank account for business use. Also, double-check records to make sure they record the correct sales tax collected.

Next, take a careful look at the figure recorded for inventory at the beginning of the year and compare it to the figure recorded for ending inventory in last year's tax records -- these items should be identical. It's also a good idea to check your residence for merchandise from your office. Make sure you've adjusted the cost of goods sold for the cost of any items taken from inventory for personal use.

Finally, the IRS recommends reviewing procedures used for taking inventory to make sure they include all items and that these items are appropriately priced. They also advise against relying on adding machine tapes as the only means of taking inventory; instead, use the inventory forms available at office supply stores. Using these forms instead of adding machine tapes helps business owners in two ways: The results are more likely to be accurate, and the forms provide a permanent record of the inventory process.

Accuracy in your bottom line
Retailers and wholesalers can verify the accuracy of their gross profit figures pretty easily. Divide your gross profit by your net receipts (gross receipts minus returns and allowances) to come up with a rough idea of the difference between the cost of goods sold and the sales price.

Next, compare this figure to your average mark-up policy -- the percentage you typically add to your costs to reach your retail price. If you observe either no difference or one that is pretty trivial, chances are that your gross profit is accurate. However, as the difference between these two numbers increases, so do the chances that you goofed while number-crunching.

The bottom line here? Make sure you figure out why these two numbers are different. Otherwise, you could be crunching numbers with the IRS later on down the road.

-- Posted Sept. 9, 1999