After you have figured the gross receipts from your business (chapter 5) and the cost of goods sold (chapter 6), you are ready
to figure your gross
profit. You must determine gross profit before you can deduct any business expenses. These expenses are discussed in chapter
8.
If you are filing Schedule C-EZ, your gross profit is your gross receipts plus certain other amounts, explained later under
Additions to Gross
Profit.
Businesses that sell products.
If you are filing Schedule C, figure your gross profit by first figuring your net receipts. Figure net receipts on
Schedule C by subtracting any
returns and allowances (line 2) from gross receipts (line 1). Returns and allowances include cash or credit refunds you make
to customers, rebates,
and other allowances off the actual sales price.
Next, subtract the cost of goods sold (line 4) from net receipts (line 3). The result is the gross profit from your
business.
Businesses that sell services.
You do not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for
your business. Your gross profit
is the same as your net receipts (gross receipts minus any refunds, rebates, or other allowances). Most professions and businesses
that sell services
rather than products can figure gross profit directly from net receipts in this way.
Illustration.
This illustration of the gross profit section of the income statement of a retail business shows how gross profit
is figured.
<emphasis role="bold">Income Statement</emphasis>
<emphasis role="bold">Year Ended December 31, 2005</emphasis>
Gross receipts
$400,000
Minus: Returns and allowances
14,940
Net receipts
$385,060
Minus: Cost of goods sold
288,140
Gross profit
$96,920
The cost of goods sold for this business is figured as follows:
Inventory at beginning of year
$37,845
Plus: Purchases
$285,900
Minus: Items withdrawn for personal use
2,650
283,250
Goods available for sale
$321,095
Minus: Inventory at end of year
32,955
Cost of goods sold
$288,140
Items To Check
Consider the following items before figuring your gross profit.
Gross receipts.
At the end of each business day, make sure your records balance with your actual cash and credit receipts for the
day. You may find it helpful to
use cash registers to keep track of receipts. You should also use a proper invoicing system and keep a separate bank account
for your business.
Sales tax collected.
Check to make sure your records show the correct sales tax collected.
If you collect state and local sales taxes imposed on you as the seller of goods or services from the buyer, you must
include the amount collected
in gross receipts.
If you are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments,
you generally do not
include these amounts in income.
Inventory at beginning of year.
Compare this figure with last year's ending inventory. The two amounts should usually be the same.
Purchases.
If you take any inventory items for your personal use (use them yourself, provide them to your family, or give them
as personal gifts, etc.) be
sure to remove them from the cost of goods sold. For details on how to adjust cost of goods sold, see Merchandise withdrawn from sale in
chapter 6.
Inventory at end of year.
Check to make sure your procedures for taking inventory are adequate. These procedures should ensure all items have
been included in inventory and
proper pricing techniques have been used.
Use inventory forms and adding machine tapes as the only evidence for your inventory. Inventory forms are available
at office supply stores. These
forms have columns for recording the description, quantity, unit price, and value of each inventory item. Each page has space
to record who made the
physical count, who priced the items, who made the extensions, and who proofread the calculations. These forms will help satisfy
you that the total
inventory is accurate. They will also provide you with a permanent record to support its validity.
Inventories are discussed in chapter 2.
Testing Gross Profit Accuracy
If you are in a retail or wholesale business, you can check the accuracy of your gross profit figure. First, divide gross
profit by net receipts.
The resulting percentage measures the average spread between the merchandise cost of goods sold and the selling price.
Next, compare this percentage to your markup policy. Little or no difference between these two percentages shows that your
gross profit figure is
accurate. A large difference between these percentages may show that you did not accurately figure sales, purchases, inventory,
or other items of
cost. You should determine the reason for the difference.
Example.
Joe Able operates a retail business. On the average, he marks up his merchandise so that he will realize a gross profit
of 33⅓% on
its sales. The net receipts (gross receipts minus returns and allowances) shown on his income statement is $300,000. His cost
of goods sold is
$200,000. This results in a gross profit of $100,000 ($300,000 - $200,000). To test the accuracy of this year's results, Joe
divides gross
profit ($100,000) by net receipts ($300,000). The resulting 33⅓% confirms his markup percentage of 33⅓%.
Additions to Gross Profit
If your business has income from a source other than its regular business operations, enter the income on line 6 of Schedule
C and add it to gross
profit. The result is gross business income. If you use Schedule C-EZ, include the income on line 1 of the schedule. Some
examples include income from
an interest-bearing checking account, income from scrap sales, and amounts recovered from bad debts.
