EXPLANATION REGARDING GROSS PROFIT MARGINS

[C.A. DEV KUMAR KOTHARI]

Gross profit margin and business policies:

In any business gross profit margin may go on changing from time to time depending on changes in several business factors. Some factors have direct link with markets and marketing practices in relation to purchase and sale of goods. Some factors have effect due to change in financing pattern.

Competition and GP rate:

In a competitive market GP rate cannot be static. In case competition amongst suppliers  is more intensified, it is likely that cost of goods bought will fall. In case competition is reduced, the prices will increase.

 In case competition in area of  marketing / selling of goods is changed, it will have effect on selling price and GP rate.

Now we have international competition. Competition is intensifying due to fast communication and transportation.

Inter firm comparison may not be relevant:

Inter firm comparison of GP rate may not be proper because results of various units being compared might have different policies relating to buying and selling of goods. For example, suppose a firm always purchase goods on cash payment basis, and another firm purchases on 30 days credit yet another firm purchases goods on 120 days credit basis. In these three cases there will be different costs of goods procured and this will have an effect on GP rate. Similarly other business policies in relation to quantity bought, source of purchasing, nearness of procurement centers and selling centers will also have effect on costs and thus on GP.

Therefore, there can be several reasons for varying GP rates amongst different firms as well as varying GP rates over different period in case of any firm.

Enquiry by The Assessing Officers and possible reply:

The A.O. usually compare GP rate and if there is a fall in GP rate he asks the assessee to explain the  reasons for the same. Addition on ground of lower GP rate are not un-common. Some time addition is also made merely due to reason that another assessee of the same A.O. is having higher GP rate.    

This situation arises many times because  assessee is not able to clearly convey reasons for fall in GP rate or lower  GP rate or because the A.O. just ignore business realities.

Year end analysis should be made:

At end of every year after the finalization of accounts an attempt should be made to analyze various factors contributing to performance of business and certain events which had a bearing on business should also be noted down. When the memory is fresh, all such reasons shall be readily recalled, if properly recorded, the same shall be helpful in making out explanation for the same. 

Illustrative draft letter to the A.O. to explain the reasons for fall in GP rate:

From:

 ASSESSEE

To

The AO

Dear Sir,

PAN

Reg: A.Y. 

With reference to  discussions  Shri       ,    my  A/R had with you and in furtherance of documents filed with the return of income and during hearing I give below the following information and explanations for your kind consideration in relation to certain changes in financial and marketing policies which took place during the year under review:

Changes in financial structure:

Our opening capital was    lakh and closing capital is    lakh. Thus, there is infusion and accumulation of  about Rs.    lakh during the year in the  capital account. 

We have availed more credit from my suppliers and service providers. This is evident from the fact that our  sundry creditors were Rs.   lakh in beginning and Rs.   lakh at the end of the previous year.  Our  loans   have also increased by Rs.     lakh during the year.

Therefore there is overall increase of funds in form of capital and borrowed funds and suppliers credit. This has helped us in increasing our  turnover to Rs.        Lakh from  lakh in earlier year. Thus we find that the turnover has increased by   about …%

To achieve higher turnover we have adopted policy of buying goods at credit and also selling some goods on credit which is reflected from the fact that  our sundry debtors have also increased by Rs.   lakh. Sale on extended credit had to be extended due to considerable fall in demand of some of products in which we deal.

Therefore, on overall basis faster turnover was considered as a policy to meet requirements of competition and to maintain loyalty of suppliers and customers both. It is very common principal of business that for  buying larger quantity and getting work done on larger quantity  higher price and labor charges are  to be paid. On the other hand  for selling higher quantity lower net price is to be charged to customers. To maintain loyalty of old customers, lower price or higher discounts and longer credit period is to be offered.

 For attracting new customers also lower price or higher discounts have to be offered. During the period under review we had added …. New customers and retained …. Regular customers. Unfortunately … customers had left buying goods from us because they preferred lower price at cost of quality and switched over to other suppliers.

Change in buying pattern:

In view of higher outdating of fast changing designs and customers preference and higher inventory costs due to use of borrowed funds we have resorted to buying goods in small quantities. This has resulted in higher cost due to higher net price charged by suppliers. Average size of  our supply receipts has reduced from Rs.3 lakh to Rs.2.6 lakh. On this account some overhead costs  in nature of ordering and procuring goods have also increased. 

Change in selling pattern:

Mix of customers have also changed. Number of customers buying in small quantities (up to Rs. 25000) have gone up from 200 to 500. This required to keep more variety of goods which we have to procure in small lots.

Ratio of whole sale customers ( above Rs.3 lakh per customer) has declined from 79% to 70%     

Sale to philanthropic organization:

During the year we had started policy to sell some goods to charitable and philanthropic organization on lower price. We sold goods worth Rs.25 lakh to such organizations on which hardly any GP was earned.

Sale in new markets:

To enter in new markets we sold goods worth Rs.150 lakh at very nominal profit margins by allowing higher discounts to garner new customers. 

Credit extended:

Sale on credit was increased from 35% to 55%. Average credit period has also gone up from 21 days to 45 days.

Fall in Gross profit margins:

In view of the some changes in financial ,marketing and other  business policies and  business model,  relating to buying and selling of goods and also financing of business, as explained in earlier paragraph, gross profit margins have  fallen from  % to    %. Changes in composition of customers and suppliers and service providers has also caused higher costs and lower realization. It is applicable in any business that to achieve a new level of operation there is increase in costs which may not be fully recovered from customers. At each new level of operation, some fixed costs are increased.  These are very common phenomena in any business. It may however, be noted that overall gross profit was increased from  lakh in earlier year to    lakh because of increased turnover.

Our  net profit has also increased from   lakh to     lakh.

Considering business realities, as a business person we feel that the our business performance was satisfactory. We  also hope that you will also find the same satisfactory in view of changed circumstances.

Gross profit margins cannot be static:

At last we may mention that due to several reasons GP rate cannot be static. In our case also GP rate has varies from year to year in small range. We recall that in PYE 31.03.2001 we had exceptionally higher rate of GP of 14% because during that year we had purchased some goods in large lot and thereafter there was sudden price escalation of those goods. In one lot we had exceptionally higher gross profit by about Rs. Six lakh. Similarly, we notice that in PYE 31.03.1997 we had faced worst year and the GP rate was only 6%  and we suffered net loss also in that year.

Accounting checks and audited accounts:

We maintain proper books of account and have reasonable internal check and control. All purchases and sales have been properly accounted for. Stocks have been reconciled. Our accounts have always been basis for determination of turnover for VAT/ St purposes and IT purposes.

In view of the above facts and circumstances and explanations we request you to do not draw any adverse inference and do not  make any addition due to lower GP rate.

Thanking you,

Yours faithfully,

Assessee