Why would a company use the gross profit method to estimate ending inventory?

The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.

Explanation

While larger companies may have sophisticated electronic systems that track items held in inventory, smaller companies may not be able to afford such systems. Instead, these companies rely on physical counts of items, which can be burdensome. Companies may elect to conduct these physical inventories only at year end due to their cost.

The gross profit method allows these companies to estimate the value of their inventories each accounting period. This method assumes the gross profit per item remains fairly consistent throughout the year.

Companies can verify the accuracy of the gross profit method by comparing the result of their estimate with those obtained during the year end physical inventory.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. Inventory errors also have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

Company A's inventory on January 1 was $175,000. Additions during the first quarter of the year were $72,500. Company A's revenues in the first quarter were $125,000 and the historical gross profit margin for this product is 40%. The inventory at the end of the first quarter would be:

Beginning Inventory$175,000Net Additions$72,500Cost of Goods Available for Sale$247,500Less: Estimated COGS (60% of $125,000)$75,000Ending Inventory$172,500

Related Terms

inventory, gross profit, balance sheet, net income, first in, first out, last in, first out, lower of cost or market, retail method, gross profit index

One sure-fire way to determine exactly what your business has in its inventory is to go in and count every single item. However, taking a physical inventory isn't always practical or even possible, so a business needs a reliable way of estimating the value of its inventory. Two of the most common methods for doing that are the gross profit method and the retail inventory method.

Purpose

1. Taking a physical inventory is necessary, but it's also time-consuming and expensive. You may have to close your business for a day or part of a day to "freeze" the inventory for counting, or you may have to pay employees overtime to come in during non-business hours to conduct the count. These considerations limit how often you can perform a physical inventory. However, between these "hand-counts," you still need information to plan your budget and prepare financial reports. In some cases, such as after a fire or robbery, a physical inventory is impossible because the items are gone, but you still must be able to estimate the value of the lost inventory to put in an insurance claim or deduct the loss on your taxes. In situations like these estimation methods come into play.

Choosing a Method

1. Each method depends on knowing the difference between how much it costs you to obtain or produce the items you sell and the price at which you sell them to customers.

   The gross profit method uses your company's current profit margin. If your company operates with a profit margin of 25 percent on sales, for example, it means that for every $1 in sales, 75 cents goes toward producing or purchasing the items you sell and 25 cents is gross profit. To determine your current margin, you must examine your recent sales and costs to determine exactly how much profit you're making. The retail inventory method uses markup -- the specific amount your company adds to the wholesale cost of goods when pricing them for retail. If you mark up goods 25 percent, for example, then an item you buy wholesale for $80 would sell for $100 -- that is, $80 plus a 25 percent markup, which is $20.

   Which method you choose depends largely on how you run your business. If you sell products with a consistent and equal markup, retail inventory is your simplest choice. However, if you sell a range of products, each of which has a different markup, gross profit would be better, although it entails the extra step of determining your current margin

Gross Profit Method

1. The gross profit method calculation starts with the value of the goods in your inventory the last time you performed a physical count. Remember that the "value" of inventory represents the cost to you, not the retail price. Say you had inventory worth $50,000 the last time you did a hand-count. Now add the amount you have spent on goods since that count. If you've spent $30,000 since then, the total cost of goods available for sale is $80,000. Next, look at your sales revenue since the last inventory. This amount will reflect the retail price of the goods sold. Say you had $60,000 in sales. Apply your gross profit margin to your sales revenue to determine the cost of the goods you sold. If your margin is 25 percent, then that $60,000 in sales represents $15,000 in profit and $45,000 in costs. Subtract that cost figure from the total cost of available goods: $80,000 minus $45,000 gives you an estimated current inventory value of $35,000.

Retail Inventory Method

1. The calculation for the retail inventory method works much the same as that for the gross profit method. Start with the inventory cost at the last hand-count and then add to that the cost of goods purchased since the count. Say these two add up to $80,000. Now take your sales revenue since the last inventory, and calculate how much of that was the cost of the goods and how much was markup. If you had $60,000 in sales and your markup is 25 percent, then those sales represent $48,000 in costs and $12,000 in markup ($12,000 is 25 percent of $48,000). Subtract $48,000 from $80,000, and your estimated current inventory is $32,000.

   In what situations would the gross profit method be used to estimate ending inventory?

   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.

   For what reasons might Management use the gross profit method of estimating inventory?

   The gross profit method might be used to estimate each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other reasons.

   What is the advantages of gross profit method?

   Gross profit margin is a useful metric for several purposes: It's a quick method for showing the margin on the company's products and lines of business. It can also serve as a barometer of a business's management or sales organization. It provides a benchmark for comparing a company's performance with competitors.

   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.