Gross profit method definition
/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. It is especially useful when a business wants to employ a soft close at the end of a reporting period, to produce financial statements as soon as possible. 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.
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How to Use the Gross Profit Method
Follow these steps to estimate ending inventory using the gross profit method:
Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.
Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.
Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.
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 Method
Amalgamated 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 Method
There 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 Incorrect
The 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 Losses
The 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). This is especially likely to be the case when the business operates retail stores in a variety of locations, where theft losses vary substantially by store; if new stores are experiencing theft losses different from the firm’s historical base of stores, then the gross profit percentage used for the gross profit method will yield incorrect results.
Limited Applicability
The 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 Period
In 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.