Back to basics: VAT registration options to take on pricing
If a business becomes VAT registered and is selling standard rated supplies, the owners have a decision to make; do they pass on the VAT cost to customers or do they absorb this cost themselves?
The following four diagrams illustrate this point firstly by showing sales income and costs of a non-VAT registered business to allow for a comparison. The cash profit in this instance is £40.
Option 1 then shows the same business with output VAT having been added to the sales price and input VAT having become recoverable on costs. The business has chosen to pass on the burden of VAT to the end consumer, whilst net costs have reduced by virtue of being able to reclaim input VAT. Cash profit is £50.
Option 2 shows how things would look if the business owners decided to absorb the cost of VAT by not increasing their selling price. The sales consideration includes VAT at 20% meaning the business now only keeps 83p in each £1 of sales income. Cash profit is £33.
With option 3, the business has been left in the same position with regard to its cash profit as it was in prior to becoming VAT registered. This has been achieved by increasing the sales price to customers but only so far as is required to cover their costs, taking account of the fact that the business is able to recover input tax on its purchases. Cash profit is £40.
The decision on which approach to take can depend on whether the customer base is VAT registered and whether competitors are VAT registered.
If customers are VAT registered businesses they may be able to recover any VAT charged on sales to them and therefore adding VAT to the sales price may not put them off continuing to buy goods in future.
If, on the other hand, customers are not VAT registered, and/or if competitors are also not VAT registered, then adding VAT to the sales price may lead to a loss of custom.