Gross Profit Method
The gross profit method uses the previous year's average gross profit margin to calculate the value of the inventory.
LEARNING OBJECTIVES
Explain how a company would use the Gross Profit Method to value inventory
KEY TAKEAWAYS
Key Points
- There a two methods to estimate inventory cost the retail inventory method and the gross profit method.
- If taking a physical inventory is impossible or impractical, it is necessary to estimate the inventory cost.
- Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.
Key Terms
- gross profit: The difference between net sales and the cost of goods sold.
- monetary: Of, pertaining to, or consisting of money.
Valuing Inventory
An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.
A company will chose an inventory accounting system, either perpetual or periodic. In perpetual inventory the accounting records must show the amount of inventory on hand at all times. Periodic inventory is not updated on a regular basis.
Methods Used to Estimate Inventory Cost
While the best way to value inventory is to perform a physical inventory, in certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. There are two methods to estimate inventory cost, the retail inventory method, and the gross profit method.
Both methods can be used to calculate the inventory amount for the monthly financial statements, or estimate the amount of missing inventory due to theft, fire or other disaster. Either of these methods should never be used as a substitute for performing an annual physical inventory.
Gross Profit Method
The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.
Inventory.: The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory.
To prepare the inventory value via the gross profit method:
- Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
- Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use projected gross profit ratio or historical gross profit ratio whichever is more accurate and reliable.
- Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
- Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.
Example
The following is an example on how to calculate ending inventory using the gross profit method.
Furniture Palace has cost of goods available for sale of $5000. Sales were $1000.
The company has projected a gross profit ratio of 25%.
The estimated cost of goods sold on the income statement for the period is$1000⋅.25=$250.
The ending inventory on the balance sheet is$5000−$250=$4750.
