EM3082 - Examining Accounts: Business Ratios: Gross Profit Rate
Gross profit rate (GPR) is the most commonly used business ratio in HMRC.
The relevance of GPR in the distributive trades is obvious but its significance will vary according to the conditions of the trade. A newsagent will have very little influence on either the buying or selling price of the commodities handled but will know what rate of gross profit can be expected within the constraints of current price structures. Therefore the newsagent will have some idea of the volume of trade needed to make a living. In other trades the trader may have a target rate (or rates) in mind and will have pricing policies based on them. The interpretation of gross profit rates is relevant to any discussion of the profits of a buying and selling business.
More detail is available under these headings.
Use of Average GPR at tribunal
Use of GPR
Although the concept is simple, skill is needed in using GPR. The limitations and possible pitfalls need to be understood. Initially, an unexpected or abnormally low rate of gross profit may raise legitimate doubts but an attempt to re-compute the true profits of a business by using the ‘mean’ or most common rates achieved by other apparently similar businesses should only be done where there is no co-operation from the trader.
As explained at EM3508, to reconstruct sales you will need to
- discover the mix of goods bought and sold by the business and any operations carried out on them
- to apply appropriate ‘mark-ups’ to specific categories
- to make any necessary allowances for wastage, sub-standard goods, pilferage etc.
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Ultimately, the GPR should not be looked at in isolation.
Comparisons
When you are reviewing accounts for enquiry, you should think about possible comparisons.
- How does the GPR compare with other businesses? The location of the business and any peculiarities of its trade should be borne in mind. However, if the business can realistically be compared with others, either nationally or locally, a lower than average GPR may be a risk indicator.
- How does the gross profit rate compare with previous years? Is there a trend, and if so how does this compare with other changes in the business? A widely fluctuating GPR would give cause for concern if the trade is one in which the terms of trading do not vary greatly year by year. Similarly a substantial rise or fall in gross profit rate in any one year may be a risk indicator.
High GPR
You should not be blinkered and consider only low GPR. The GPR is only part of a bigger picture. Obviously that is a clear indication that margins are depressed for commercial or other reasons. However, you will be trying to obtain a picture of the business as a whole and understand how it works. What might an unusually high GPR indicate? Do other ratios and trends conform with high margins?
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Sensitivity of GPR
The sensitivity of GPR is greatest where the turnover is modest. Where it is large, say £200,000, the omission of £2,000 from sales will show a difference in the rate of gross profit of only 1% of sales. In such cases, it will usually be necessary to demonstrate and correct specific errors in the accounts or business records. However, the existence of a high turnover figure does not mean that GPR can be ignored. Gross discrepancies do come to light in some cases. Looked at from another point of view, the insensitivity of GPR in large cases means that a ‘good’ rate of gross profit should not deter you from opening enquiries if there are other risk indicators.
Use of Average GPR at tribunal
Average gross profit rates have very limited uses if the case goes to a tribunal hearing. Can the Tribunals Caseworker get details of other gross profit rates in as evidence and, if so what will those details prove? Firstly even an enquiry officer who has spent many years on enquiry work is most unlikely to be accepted by the tribunal as an expert on the trading patterns and operations of any particular type of business. Although he or she may be an expert investigator they do not become an expert on any particular type of business as it is most unlikely that enough examples of that particular type have passed through their hands to make him or her an expert. Their opinion on trade practices and likely results is therefore inadmissible as evidence.
The Tribunals Caseworker cannot simply try to put in a summary of gross profit rates showing what other businesses have achieved (and by inference casting doubts on the taxpayer’s results). There is the very real objection that this is probably a breach of confidentiality. Such information is hearsay evidence and it is unlikely to be directly relevant to the issues being considered by the tribunal. There may well be objection to its introduction.
Evidence about other businesses such as average profit rates or levels is not evidence about the taxpayer’s business. It can be a justification for selecting a case for enquiry. Equally, it may have assisted you in making a ‘best of judgement’ assessment, and it is quite in order to say so. What the tribunal needs is evidence to demonstrate that the taxpayer’s profits are inadequate.