Whether a company uses a periodic or perpetual inventory system, a
physical inventory (i.e., physical count) of
goods on hand should occur from time to time. The quantities determined via the physical count are presumed to be correct, and any differences should result in an adjustment of the accounting records. Sometimes, however, a physical count may not be possible or is not cost effective, and estimates are employed. One such estimation technique is the gross profit method. This method might be
used to estimate inventory on hand for purposes of preparing monthly or quarterly financial statements, and certainly would come into play if a fire or other catastrophe destroyed the inventory. Very simply, a company’s normal gross profit rate (i.e., gross profit as a percentage of sales) would be used to estimate the amount of gross profit and cost of sales. Assume that Tiki’s inventory was destroyed by fire. Sales for the year, prior to the date of the fire were $1,000,000, and Tiki usually
sells goods at a 40% gross profit rate. Therefore, Tiki can readily estimate that cost of goods sold was $600,000. Tiki’s beginning of year inventory was $500,000, and $800,000 in purchases had occurred prior to the date of the fire. The inventory destroyed by fire can be estimated via the gross profit method, as shown. Retail MethodA method that is widely used by merchandising firms to value or estimate ending inventory is the retail method. This method would only work where a category of inventory has a consistent mark-up. The cost-to-retail percentage is multiplied times ending inventory at retail. Ending inventory at retail can be determined by a physical count of goods on hand, at their retail value. Or, sales might be subtracted from goods available for sale at retail. Crock Buster sells pots that cost $7.50 for $10. This yields a cost-to-retail percentage of 75%. The beginning inventory totaled $200,000 (at cost), purchases were $300,000 (at cost), and sales totaled $460,000 (at retail). The only”givens”are highlighted in yellow. These three data points are manipulated by the cost-to-retail percentage to solve for ending inventory cost of $155,000. Be careful to note when the percentage factors are divided and when they are multiplied.  Need help preparing for an exam?Check out ExamCram the exam preparation tool!
Principlesofaccounting.com ™ Copyright © 2022. All rights reserved. What is the Gross Profit Method?The gross profit method estimates the amount of ending inventory in a reporting period. This is of use for interim periods between physical inventory counts. It is also useful when inventory was destroyed and you need to estimate the ending inventory balance for the purpose of filing a claim for insurance reimbursement. The gross profit method is not an acceptable method for determining the year-end inventory balance, since it only estimates what the ending inventory balance may be. It is not sufficiently precise to be reliable for audited financial statements. How to Use the Gross Profit MethodFollow these steps to estimate ending inventory using the gross profit method:
In addition, it is useful to compare the resulting cost of goods sold as a percentage of sales to the recent trend line for the same percentage, to see if the outcome is reasonable. Example of the Gross Profit MethodAmalgamated Scientific Corporation (ASC) is calculating its month-end inventory for March. Its beginning inventory was $175,000 and its purchases during the month were $225,000. Thus, its cost of goods available for sale are: $175,000 beginning inventory + $225,000 purchases = $400,000 cost of goods available for sale ASC's gross margin percentage for all of the past 12 months was 35%, which is considered a reliable long-term margin. Its sales during March were $500,000. Thus, its estimated cost of goods sold is: (1 - 35%) x $500,000 = $325,000 cost of goods sold By subtracting the estimated cost of goods sold from the cost of goods available for sale, ASC arrives at an estimated ending inventory balance of $75,000. Problems with the Gross Profit MethodThere are several issues with the gross profit method that make it unreliable as the sole method for determining the value of inventory over the long term, which are noted below. Historical Basis Could Be IncorrectThe gross profit percentage is a key component of the calculation, but the percentage is based on a company's historical experience. If the current situation yields a different percentage (as may be caused by a special sale at reduced prices), then the gross profit percentage used in the calculation will be incorrect. Assumes Inclusion of Inventory LossesThe calculation assumes that the long-term rate of losses due to theft, obsolescence, and other causes is included in the historical gross profit percentage. If not, or if these losses have not previously been recognized, then the calculation will likely result in an inaccurate estimated ending inventory (and probably one that is too high). Limited ApplicabilityThe calculation is most useful in retail situations where a company is simply buying and reselling merchandise. If a company is instead manufacturing goods, then the components of inventory must also include labor and overhead, which make the gross profit method too simplistic to yield reliable results. Short-Term Usage PeriodIn general, any inventory estimation technique is only to be used for short periods of time. A well-run cycle counting program is a superior method for routinely keeping inventory record accuracy at a high level. Alternatively, conduct a physical inventory count at the end of each reporting period. Why would a company use the gross profit method to estimate ending inventory?This is of use for interim periods between physical inventory counts. It is also useful when inventory was destroyed and you need to estimate the ending inventory balance for the purpose of filing a claim for insurance reimbursement.
When might it be useful for a company to use the gross profit method or retail method of estimating inventory?One such estimation technique is the gross profit method. This method might be used to estimate inventory on hand for purposes of preparing monthly or quarterly financial statements, and certainly would come into play if a fire or other catastrophe destroyed the inventory.
What is the gross profit method of inventory?The gross profit method estimates the value of inventory by applying the company's historical gross profit percentage to current‐period information about net sales and the cost of goods available for sale. Gross profit equals net sales minus the cost of goods sold.
What is the advantages of gross profit method?Figures obtained from the gross profit method are a useful budgeting tool. Firms estimate the amount of inventory that they should hold based on their estimated sales. They also are able to estimate the value of ending inventory with a given level of sales income, purchase amounts and beginning inventory.
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For what reasons might Management use the gross profit method of estimating inventory?
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