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. Show
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. Inventories - TOA 86%(7)86% found this document useful (7 votes) 7K views19 pagesDocument Informationclick to expand document information
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Home Books Audiobooks Documents Which statement is true about the gross profit method?Which statement is true about the gross profit method of inventory valuation? When calculated on selling price, it will always be more than the related percentage based on cost.
Which of the following does not affect gross profit?Not included in the gross profit margin are costs such as depreciation, amortization, and overhead costs.
What does the gross profit method assume?Definition of Gross Profit Method
The gross profit method of estimating ending inventory assumes that the gross profit percentage or the gross margin ratio is known. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20.
When should the gross profit method of inventory valuation not be used because it is invalid?The GP method will be invalid in the case where GP margin on sales differs from the margin on closing inventory. This states that on a notable difference in the GP margin, this method will be invalid since the primary assumption to use it is that the GP margin will not change.
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